5 Things I Wish I Knew about the CFA Level I Exam

Last week, I listed out the things I wish I knew before each level of the CFA exams. For the most part, these were the general ideas that relate well across all three levels. This week, I am reminiscing back to those bygone days of the Level I CFA exam.
Continue reading

CFA Level 1 – Download Free Formula Sheet – PDF

Reading through the LinkedIn group lately, someone was asking about the difficulty of the CFA Level 1 exam and how it related to another professional exam. A couple of candidates commented how tough the material was and how much there was of it.

I just had to smile.
Continue reading

CFA Curriculum Warning: Do Not Neglect

The actual length of the CFA curriculum varies a little each year but it’s generally between 2,500 and 3,200 pages. When you get the books in the mail, or receive the digital version, that may seem like a monstrous task. Over the three years of studying for the exams, I think my upper body strength grew just as much as my financial knowledge just from carrying the books around.

Study guides meant to substitute for the curriculum vary but generally range between 1,400 and 1,700 pages. At under two-thirds the length of the official curriculum, it seems like a no-brainer and I know many candidates who have only rarely even peaked inside their curriculum books.

And many of them are still candidates.

Do Not Neglect the Official CFA Curriculum!

Candidates that have tried to substitute the CFA curriculum with study guides have come to me afterwards with their horror stories. My reply is always the same, “I wish we had talked before because if you do the math then the answer is pretty obvious.” The minimum passing score for the exams is never released but I would guess it is around sixty-five percent. No candidate has failed with a score of 70% or better and I doubt if the Institute would want to charter someone that knows less than two-thirds of the subject matter.

Even the most gifted candidates are going to miss points. If about half the candidates fail the exam every year, I am guessing that most miss at least a tenth of the points and probably much more. We have no way of knowing but it’s obvious that you need every point you can get.

Now, I have seen pretty much all the study guides commercially available. There are some that do a pretty good job of condensing the material but none are able to get everything in a packet that is half the length of the curriculum. It’s impossible and information is going to get left out. Try to fit nearly 3,000 pages of information in less than 2,000 pages of notes and I would say you’re lucky if 20% of the information isn’t lost.

So if you neglect the official curriculum completely, you are already out something like 20% or more of the points. Now you need to remember at least 80% of the material just for a score of 64% on the exam.

Most of you have taken practice exams through test banks or the CFA Institute. How many have scored better than 80% on these? I know reading all those books is a daunting task but you just cannot afford to leave points on the table by neglecting the official curriculum.

CFA Study Guides

I don’t talk about the FinQuiz study notes much here on the blog other than to reference specific sections of the notes and the curriculum. I don’t want candidates to think I am being biased by pushing one particular study provider over another. But I can say, without any bias, that the FinQuiz notes have at least one big advantage over other study products, that they are meant to be used as a complement to the curriculum instead of a substitute.

The FinQuiz notes vary by length as well but are generally around 600 pages. It’s really the best of both worlds, you get 100% of the information from the curriculum and additional condensed explanations where you need them.

Free examples of the FinQuiz notes are available for download on the website. Take a look and compare them with the curriculum. FinQuiz regularly offers discounts on products and packages so you may want to contact the provider to get the best deal possible.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: August 10, 2016 at 4:30 am

CFA Level 1 Curriculum Review: Financial Statement Analysis

Reading 28 in the CFA curriculum combines the financial statements with key ratios and analysis

This is the fifth week of our CFA Level 1 review of the financial statement material. Reading 28 is your first look into the financial statement analysis and techniques that will make up a big portion of your CFA level 2 exam. In all, financial reporting and analysis accounts for 20% of your level 1 points and up to 20% of the second exam.

Check out the introduction to CFA Level 1 Financial Statements
Check out the CFA Level 1 Income Statement Review
Check out the CFA Level 1 Balance Sheet Review
Check out the CFA Level 1 Statement of Cash Flows Review

Some of the ratios and financial analysis techniques you’ll see in reading 28 have already been discussed in the separate readings on each financial statement. Besides specific techniques used in analysis, pay attention to assumptions used in different techniques and the limitations of each method.

Ratios and Common-Size Financial Statement Analysis

Ratios in financial statement analysis offer a way to standardize information and compare results across companies. It can be used to compare current results with past performance as well. Ratio analysis is limited across companies because each might operate in a slightly different product category or market. Differences in accounting practices can distort ratios and there’s no definite set of ratios that will tell you all you need about a company.

Activity ratios measure management efficiency in day-to-day operations. I’ve included some of the most common ratios used below. Activity ratios are also called asset utilization ratios. Notice that when you use Balance Sheet data in a ratio with another financial statement, you need to take the average of the beginning and ending number reported on the Balance Sheet.

cfa activity ratiosSolvency ratios measure the firm’s ability to meet long-term obligations. Liquidity ratios measure the firm’s ability to meet short-term obligations. Pay attention to the Cash Conversion Cycle which reflects the number of days a company’s cash is tied up in the operating cycle. The conversion cycle equals the number of days inventory plus days receivable outstanding minus the number of days accounts payable outstanding.

Understand the difference between operating leverage and financial leverage. Operating leverage comes from using fixed costs in the company’s business and magnifies the effect of sales growth on operating income. Financial leverage comes from the use of debt and magnifies the effect of changes in EBIT on net income.

cfa debt and liquidity ratiosProfitability ratios measure overall performance and margins. Gross, operating and net margin are used often to show different ideas of profitability.

cfa profitability ratiosIt may seem like a lot of ratios to memorize but they are fairly easy to remember after some repetition. Write the ratios and a brief explanation on some flash cards and review them each day until you’ve mastered the concept.

Common-size financial statement analysis is helpful in spotting trends within a company’s results as well as comparing accounting line items across firms. A horizontal common-size statement compares an accounting item like sales or operating expenses against itself from another year. It’s helpful in finding growth across time in each line item. A vertical common-size statement compares an accounting item against another line in the same year, usually against sales or total assets. It’s helpful in comparing the proportion of a line item in one company against another.

For common-size analysis on the balance sheet, you’ll use total assets as the common item. For analysis on the income statement, sales are used as the common item for comparison.

There’s quite a bit more in reading 28 including DuPont Analysis and some important ratios for equity analysis. All the ratios in the reading could easily show up on the CFA exam since they’re pretty easy to test in a quick question. The best way to approach the material is to understand the concept of the ratio. Instead of just rote memorization of the equation, understand what the components are and how they relate to each other. You’ll find it much easier to remember the mountain of ratios and equations for the exam.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA 2016 Review: Level I Balance Sheet

Master this introductory material on the balance sheet in the 2016 CFA Level 1 curriculum to breeze through tougher concepts later

This is our third week of reviewing the CFA Level 1 Financial Statement material, following the introductory reading and income statement analysis last week.

We begin on our review of the Balance Sheet, reading 26 of the CFA Level 1 curriculum, this week. The balance sheet is not quite as talked about among investors as the income statement but is no less important. Understand how the balance sheet relates to the other two statements, especially how assets are depreciated and expensed.

Understanding the Balance Sheet

The Balance Sheet financial statement is different from the other statements in that it is a snapshot in time rather than a presentation of activity over the period. The Balance Sheet shows assets, liabilities and owner’s equity as of the last day in the reporting period.

Assets represent economic resources of the company, resources that can be used to generate cash or sales. Liabilities are current or future obligations of the company, representing an outflow of economic benefit. Owner’s equity represents the remaining assets or economic resources after all creditors (liabilities) are paid. This gives rise to the balancing of the Balance Sheet with Assets equaling liabilities and equity.

Assets and liabilities are presented in terms of liquidity. Assets that are highly liquid like cash or those that can be converted to cash are show first. Those liabilities that are expected to be paid within a year are shown first in short-term liabilities. The remaining assets and liabilities are shown in long-term accounts because they are expected to be used or paid out over more than a year.

cfa level 1 review balance sheetUnderstand that some of the assets on the Balance Sheet will have a contra-asset and the difference between historical value and net. Accounts receivable is offset by the allowance for doubtful accounts for Net Receivables. Property, Plant and Equipment is offset by depreciation for its net value.

There is a lot of accounting concepts on the balance sheet but you must know them to be a good analyst. You’ll go into more detail on how inventories, long-term assets and other accounts are depreciated, expensed and recorded in other readings. If you don’t have a strong background in accounting, it’s imperative that you spend the time necessary to master this introductory material so you can understand the more detailed readings.

The differences between U.S. GAAP and IFRS reporting can be tedious and confusing. It’s best if you put together a table for each financial statement. Label the different accounting items (inventory, PP&E, etc) down the left-side column followed by columns for GAAP and IFRS. This makes for a quick review of the differences that you can use a few times a day until you’ve got them committed to memory.

An important distinction on the Balance Sheet is the classification of financial assets. Financial assets (liquid assets in stocks and other securities) are either classified as Held-to-Maturity, Held-for-Trading, or Available-for-Sale. How the asset is classified will affect how it’s value is recorded and how the gains/losses show through to the income statement.

  • Held-to-Maturity assets are measured at amortised or historical costs and no unrealized gains/losses are reported.
  • Held-for-Trading assets are recorded at fair value and marked to market with unrealized gains/losses recognized as profit/loss on the income statement and in retained earnings.
  • Available-for-Sale assets are recorded at fair value with unrealized gain/loss recognized on Other Comprehensive Income and accumulated within owner’s equity.

Balance Sheet Analysis

As with the reading on the Income Statement, the analysis here is fairly light with just some ratios. The reading is focused more on the accounting concepts for the Balance Sheet while other readings will go deeper into the analysis.

In ratio analysis, you must remember to adjust your Balance Sheet numbers when using them with numbers from the other financial statements. It’s easier than it sounds, you just need to take the average of the beginning and ending values for the Balance Sheet number.

For example, the Days Sales Outstanding ratio is found by taking the average of the beginning and ending receivables on the balance sheet and then dividing by sales or credit sales from the income statement.

Make sure you understand and remember the liquidity ratios and the solvency ratios. These are very basic and will be used throughout the CFA exams and your job as an analyst.

Liquidity Ratios: Current, Quick (acid-test), Cash
Solvency Ratios: Long-term Debt to Equity, Debt to Equity, Financial Leverage

We’ll continue with the Statement of Cash Flows next week and then a week for financial statement analysis. Make sure you are scheduling enough study time to read through the curriculum, work practice problems and then review study notes. It’s only this repetitive system of studying that will allow you to commit the material to memory.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Understanding Financial Statements

Don’t neglect this basic information on financial statements in the CFA curriculum

One of the most important topic areas in the CFA curriculum is Financial Statement Analysis, which accounts for upwards of 20% of each exam’s points. Reading 22 of the CFA Level 1 curriculum is your first step into the world of financial statement analysis and a critical skill you’ll need during your career.

I thought it would be helpful to point out some of the highlights of the Finquiz Study Notes on the reading and some other tips to the Level 1 CFA material within financial statement analysis. Over the next few weeks, we’ll cover the other key topic areas and readings in the CFA level 1 exam to help you get the most points possible.

An Introduction to Financial Statement Analysis

The Finquiz study notes for Reading 22 is eight pages long and covers all the learning outcome statements for the material. Rather than a substitute for the curriculum, Finquiz notes are meant to complement your reading of the CFA curriculum to make sure you cover all the material and reinforce the most important points.

The overview section on financial statements and supplementary information is a brief outline of purpose for the financial statements and other information you’ll need to research as an analyst.

Balance Sheet – a snapshot of the company’s financial position at one moment in time. The ‘snapshot’ idea is important because the other financial statements show activity over the entire period. Since the balance sheet differs in presentation, you’ll need to adjust the numbers when comparing against the other statements, i.e. taking an average of the beginning and ending balance sheet amounts.

The balance sheet categorizes everything broadly into assets, liabilities and owners’ equity. Within assets and liabilities, the items are also categorized by short-term and long-term in terms of liquidity.

The Income Statement is the financial results of a company over the quarterly or annual period. Revenues and expenses are recorded according to accrual accounting principles meaning they are matched appropriately though may not reflect actual cash activity.

Your first task will be to understand the difference between items that go in normal operating expenses and those that appear below because they are unusual or infrequent. You’ll also need to understand the general layout of the income statement and ratios like gross margin, operating margin and net margin.

While the income statement is popular with investors, you’ll spend much of your time on the Statement of Cash Flows as an analyst. The statement is an accounting of the actual cash flows of the business over the period. Since it represents actual cash flows, it is less easily manipulated by management compared to the income statement so a very valuable tool for analysis.

Cash flows are separated into three categories:

  • Operating cash flows are generated from normal day-to-day business operations
  • Cash flows from investing are attributed to the company’s long-term investing and disposal of assets
  • Cash flows from financing are attributed to the company’s use and sources of capital like debt and returning cash to shareholders

The Statement of Changes in Owners’ Equity is not quite as important as the other financial statements but you will still need a basic understanding of the components and how it relates to the other statements. Components of the statement include: paid-in capital, retained earnings, minority interests and other comprehensive income.

Beyond these four statements, you will also need to remember what supplementary information can be found in the financial statement footnotes and the Management Discussion & Analysis. These supplementary schedules and items are not as important as the financial statements but you’ll need to know what they include.

You won’t use the Auditor’s Report for much of anything but need to know the layout of the report as well as the difference between the four types of opinion.

  • Unqualified opinion – indicates that the financial statements appear to be free of material misstatements and are prepared in accordance with accounting principles
  • Qualified opinion – indicates some exceptions to accounting standards and perhaps some concerns about the company
  • Adverse opinion – indicates material misstatements and problems in the presentation according to accounting principles
  • Disclaimer of opinion – is given when an auditor is unable to issue an opinion

CFA Level 1 Review: Financial Statement Analysis Framework

The steps in the analysis framework are not as important as the process itself. Working through the readings on each financial statement will give you a good idea of the process. You might want to briefly look over each of the six steps in the process but it is unlikely that you’ll be tested on knowing the name of a specific step.

  • Articulate purpose and context of the analysis – why are you performing the analysis?
  • Collect input data – from financial statements and other sources
  • Process data – adjusting financial statements, ratios and comparing data on common-size
  • Analyze and interpret – produce analytical results
  • Develop and communicate conclusions
  • Follow-up

You’ll go into much more detail on the financial statements and FSA further into the curriculum. Some of this introductory material may seem overly simplified and unnecessary. If you have significant accounting or analysis experience, you can probably skim through it quickly but I would warn against skipping it entirely. The CFA curriculum is very well constructed to be a progressive learning process. Learning the basics in these introductory chapters will make subsequent chapters easier to understand. Skipping the seemingly easy stuff risks missing out on something you will need to know later in the curriculum.

‘til next time, happy studyin’
Joseph Hogue, CFA

How do Curriculum Changes affect your CFA Study Plan?

For the most part, your CFA study plan probably hasn’t changed over the last few years. The curriculum usually only changes by minor details from year-to-year and the format of the exams remains the same. This year brought the biggest curriculum changes I’ve ever seen as well as changes to topic weights.

Is it time to reassess our basic study strategies?

Changes to the 2015 CFA Curriculum

We detailed changes to the CFA curriculum across each exam in August of last year. The Level 1 CFA curriculum saw six readings dropped and added three new readings. Ten readings were dropped from the Level 2 CFA curriculum while six were added. The Level 3 CFA curriculum saw relatively minor changes with two dropped readings and one added reading.

While these changes will certainly affect your study plans, especially if you are repeat tester, it is the change in topic weights that will drive the biggest transformation in your study.

In the Level 1 and Level 2 exams, almost all the changes made bring the topic weights closer together. The topics that have historically been core areas for focus had their weightings come down slightly while secondary topic areas rose in importance.

On the Level 1 CFA exam, Fixed-Income (one of the most heavily weighted topics in the past) dropped to 10% of the test while historically less influential topics on the exam like Portfolio Management and Alternative Investments both increased in importance.

On the Level 2 CFA exam, Financial Reporting and Equity Investments (the two most important topics in the past) both saw their potential weightings decrease. Fixed Income and Ethics both increased in importance while Alternative Investments decreased in weighting.

The topic weights for the Level 3 exam did not change much either so there will probably not be much need to change your study strategy.

2015 CFA Exam Topic Weights

2015 CFA Exam Topic Weights

Changes to our Basic CFA Study Plan

The format of the exams has not changed. The CFA Level 1 exam is still 240 multiple choice questions, each with three possible answers. The CFA Level 2 exam is still 20 vignettes of six multiple-choice questions each for a total of 120 questions. The CFA Level 3 exam is still an essay in the morning followed by 10 vignettes of six questions each in the afternoon.

The change to your study plan will come from the fact that you may no longer be able to focus on just a few topic areas. Portfolio Management, Alternative Investments, Derivatives and Corporate Finance are still secondary topic areas in the Level 1 exam but now there are six topics that each account for a tenth or more of your total score. Every topic in the Level 2 exam has the potential of being a tenth or more of your total score and you’re guaranteed to see at least 10% of the questions in four topics.

Ethics continues to be a very important topic area, especially since the readings really don’t change for each level so you can really get a head-start by focusing on it for the first exam. Financial Reporting continues to be an important topic as well though a topic weight isn’t given for the third exam. While their importance may be lower in the first exam, Equity and Fixed-Income Investments continue to be relatively important to the final two exams.

The CFA exams saw some of their biggest curriculum changes in years for 2015 and you should take it into account when planning your study schedule. While many of the important focus topics are still relatively high-value, you might have to spend a little more time on other topics. Check out the changes to readings in our post for each specific exam for clues on what subjects within the topics are being favored.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:30 pm

CFA Level 1 Review: Fixed Income

Study Session 16 in the CFA Level 1 curriculum concludes the Fixed Income topic area with two readings, one on risk and return concepts and another on basic credit analysis. The credit analysis reading is completely conceptual and probably secondary to the first reading.

When I took the Level 1 exam, I was surprised by how conceptually-focused it was and how many of the formulas that I had studied for hours were not tested. They say the Level 1 exam is a mile wide and an inch deep because the curriculum touches a seemingly endless number of areas but does not go into much detail. For this reason, I always recommend to Level 1 candidates to focus on getting the main ideas and reasoning behind the concepts then to work on learning formulas.

This is especially true in SS16 with quite a few new formulas on duration and convexity. You will definitely need the basic duration and convexity formulas for the level 2 exam, so spend a little extra time here. You may or may not need to remember the formula for Macaulay duration, I would consider it of secondary importance to the others. Whatever you do, make sure you understand the concept of duration and convexity above all else.

Understanding Fixed Income Risk and Return

There are three sources of return for a bond; coupons, reinvestment and the return of face value. It is imperative that you understand how rising or falling rates affect the value of coupons and reinvestment opportunities.

If rates increase, the value of a bond decreases to make the yield competitive (i.e. since the coupons do not change, new investors/demand for the bond will require a market competitive yield so the price must change). If rates fall, the value of the bond increases but investors are exposed to reinvestment risk because of lower rates.

Understand how the time to maturity affects these concepts as well. The value of a long-term bond will rise and fall more with changes in interest rates because the change in reinvestment return has longer to affect the value.

This idea of rate risk on a bond’s price is known as Yield Duration (or just Duration). There are four measures: Macaulay, Modified, Effective, dollar and Price value of a basis point. The modified, effective, and dollar duration and PVBS are probably the most important to remember for the exam.

Modified Duration is the price of the bond at the lower rate minus the price of the bond at the higher rate (PVlow –Pvhigh) divided by two times the change in yield times the initial price (2*Yieldchg*PV0). It is a fairly easy formula to remember if you think about the concept first. You are measuring rate sensitivity so the numerator is the change in value with a change in rates. The denominator is the initial price times how much the rate change caused yield to change and multiplied by two. It may take a few practice problems but make a flash card and you’ll get it.

Effective Duration is basically the same formula but using the yield curve instead of the change in the bond’s yield. Understand that the Modified and Effective Duration will be different but will move closer together when: yield curve is flatter, maturity is shorter, price of bond is closer to par.

Understand the advantages and limitations to each method of measure for portfolio duration.

You will definitely need dollar duration for the second and third exam. Fortunately, once you have the basic duration formulas down then dollar duration is easy to remember.

The price value of a basis point is an estimate of the change in price when YTM changes one basis point. It’s a pretty quick and easy formula; the change in price with high and low rates (PVlow –Pvhigh) divided by two. Don’t forget that a basis point is one-hundreth of a percent (0.0001).

Convexity is also a very important concept in the reading. While duration only estimates the change in price from changes in rates, convexity measures the difference in that estimate on rate changes. Convexity will differ from duration the most when rates are much higher or much lower. Understand that callable bonds have negative convexity at lower rates because of the call option.

Fundamentals of Credit Analysis

The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.

Understand the forms of credit risk:

  • Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade
  • Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness
  • Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

  • Capacity is the ability of the borrower to meet debt obligations
  • Collateral is the quality and value of the assets supporting the debt
  • Covenants are the terms and conditions in a bond agreement
  • Character is the quality of management and willingness to satisfy debt obligations

The curriculum throws a ton of ratios at you to measure liquidity and financial strength but they are all discussed in more detail in other sections. Quickly understand how the ratio shows higher or lower credit risk but I wouldn’t spend too much time here. Study them in the equity and FRA topic areas where more detail is provided.

Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).

Just a month and a half left to the exam. You should be well on your way to finishing your first pass through the curriculum and ready for a review of the more difficult/important topics. Start taking mock exams built off of question banks and end-of-chapter questions as well to start getting ready for the long 6-hour exam. These mock exams will help measure how you do when you have to sit down and test every topic area at once instead of individually.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Equity Markets

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48). The material is almost completely conceptual and likely not worth a ton of points but still worth your time. Since it is all basic-level and conceptual, it is pretty easy to understand and you only need the basic idea to get any points on the exam. Make sure you understand the vocabulary and concepts, including any lists and advantages/limitations on comparisons given.

Market Organization and Structure

This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.

Understand the difference between assets; i.e. fixed-income, equities and pooled investment vehicles. You likely won’t need much other than the brief definitional material for futures, options, swaps and commodities. Most of these assets are covered in much more detail in other parts of the curriculum.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16.

While the likelihood of seeing much of this one the exam is pretty low, make sure you have a basic grasp of the material. Understanding how the markets are organized and the primary players is an absolutely basic requirement to understanding how the markets operate. It should be repeat information for Finance students but will get you up to speed if you are from a different educational background.

Security Market Indices

The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.

Price-weighted indices are based on the price of each stock. This means that higher-priced stocks will have more influence on the index. It is simply calculated but biased to the higher-priced stocks and may involve a downward bias. Stock splits, spinoffs and constituent changes will all affect the divisor.

Equally-weighted indices are based on an equal-dollar amount in each stock. The advantage is that it is also easily calculated but it may bias towards small-cap firms because there are more of these in the market. It also requires frequent rebalancing (higher transaction costs) and contains potentially illiquid stocks.

Market-cap weighted indices are based on the value of each stock company in the index. Advantages include a better representation of each company’s value in the market though the index will be biased to larger firms. The index may overweight stocks that have seen their value increase (overvalued) against those that have decreased in value.

Understand the uses of indices; i.e. measuring market sentiment, as a proxy for asset classes, as benchmarks for managed portfolios and as the bases for new products.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.

Market Efficiency

The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.

Know the difference between market value (the current price in the market) and intrinsic value (value based on investment characteristics). Depending on the efficiency of the market, these two values may differ widely.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form. Understand the implication this has on active portfolio management, i.e. that gross performance will likely mirror the market but will underperform after fees.

Remember the factors contributing to or impeding efficiency in market prices:

  • Greater number of participants should contribute to market efficiency through consensus
  • Information availability and financial disclosure should promote fairness and efficiency
  • Limits to trading like restrictions on short-selling and operational inefficiencies (high transaction costs, difficulties in execution) impede market efficiency

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea. Understand that most of these anomalies are limited due to market knowledge that they exist and front-running.

Understand the basic idea behind the eight behavioral biases, which will be even more important in your Level 3 exam.

  • Loss aversion is bias that investors dislike losses much more than the want gains and will hold on to losers to avoid losses much longer than they should.
  • Overconfidence is the tendency to overestimate your own ability to predict/forecast prices and other market indicators. Often leads to undiversified portfolios.
  • Representativeness is the bias that investors give greater weight of probability to the current situation, i.e. investors overweight current information and trends and tend to neglect new information or trends.
  • Gambler’s fallacy is the bias to project long-term reversion to the mean, i.e. that falling stocks will reverse direction based on no fundamental change
  • Mental accounting is the bias to mentally track gains and losses for different investments within separate ‘buckets’ rather than as a whole portfolio view
  • Conservatism is the bias to under-react to new information and tendency to stick to prior views
  • Disposition effect is the tendency to avoid regret by selling winners too early and holding on to losers too long
  • Narrow framing is the tendency to analyze a situation in isolation, ignoring the larger context and forces

Again, most of this stuff is perfect for flash cards and a quick understanding of basic ideas. Just make sure you have the concepts and move on to spend more time on more important study sessions.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Financial Reporting Quality

Study session ten in the CFA Level 1 curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35). Towards the end of the week, after you’ve read through the study session, it would be a good idea to take a small mock-exam over the FSA topic area. Use the end-of-chapter problems or a question bank to work through 100-200 questions. If you do not score at least 65% or better, you may want to build in some FSA review over the next couple of weeks. The topic is probably the most important in the curriculum and to your career.

Financial Reporting Quality

The reading, and much of the curriculum in FSA, revolves around your ability to understand aggressive and questionable accounting practices. Companies using more conservative accounting practices are more likely to surprise on the upside while those using aggressive assumptions may be signaling weakness.

A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Motivation to artificially increase earnings could be to meet expectations, meet debt covenants or to improve incentive compensation. Understand that management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters.

The list material behind red flags is fairly testable so understand the risks. The curriculum describes the ‘Fraud Triangle’ and three conditions that are generally present when it occurs.

  • Incentives and pressures include pressure on management to meet expectations, financial targets, debt covenants, and their own financial well-being
  • Opportunities include the nature of the industry, a complex organizational structure, ineffective monitoring, a significant number of estimates build into the accounting system, high turnover or ineffective audit staff
  • Attitudes and rationalizations include the use of inappropriate accounting, poor communication channels, failure to correct reportable conditions, and a history of violations

The most important material is the specific warning signs and the measures to spot them.

  • aggressive revenue recognition (bill-and-hold sales, sale-leaseback, swaps and barter to generate sales)
  • operating cash flow out of line with earnings, i.e. if earnings are increasing or positive while operating cash flow is decreasing or negative may be an indication that management is manipulating earnings (CFO/Net Income)
  • Classification of expenses as extraordinary or nonrecurring
  • LIFO liquidations occur when management uses the LIFO method and runs the balance lower to year-end. Watch the LIFO reserve for clues of LIFO liquidation.
  • Margins significantly out of line with peers without other explanations – overstatement of inventory or capitalization of costs is a clue that management is using aggressive accounting with expenses. Check the company’s margins against prior years and quarters as well.
  • Assumptions behind depreciation – using a longer life estimate for machinery than peers will lower depreciation expense and increase earnings but may not appropriately match costs with sales.
  • Assumptions used in pension accounting – Using a higher discount rate or higher expected return on plan assets will decrease pension expense but may lead to a problem down the road when the assumptions are corrected. As with most of the warning signs, compare assumptions with peers in the industry
  • Fourth quarter surprises that cannot be attributable to seasonality
  • Excessive use of operating leases or other off-balance sheet financing – the company may be guaranteeing some contracts or receiving financing that is not accounted for on the balance sheet, this reduces liabilities relative to peers and makes the balance sheet look more healthy than reality.

Accounting Shenanigans on the Cash Flow Statement

Understand that the cash flow statement is less easily manipulated but management can still distort the various accounts.

  • Stretching out payables (look for a trend in days sales payable) – accounts payable increases and may indicate problems paying suppliers
  • Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods – this is basically taking out a loan to pay for current expenses. The problem is that it does not appropriately match expenses with sales and later quarters will be affected
  • Securitization of receivables and whether it is through a bankruptcy-remote VIE – The problem here, and with many of the other questionable accounting tactics, is sustainability. Securitizing (selling off your receivables) increases cash flow for the current quarter but the company may still be responsible for collecting those sales. The company may have to pay back some of the proceeds in subsequent periods if default on receivables is higher.
  • Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
  • Stock buybacks to offset dilution – Since buybacks are listed under financing cash flows, analysts need to reclassify net cash paid to buyback shares from financing outflow to operating cash outflow.

Financial Statement Analysis: Applications

Really nothing new in this reading, just a review of the previous material. The reading gets into a little more detail but remember that the Level 1 exam is all about the basic ideas and reasons. Start with understanding the processes for evaluating past performance and projecting financial performance then move on to ratios.

Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets), using the ratios from past periods is how you will estimate going forward. Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets, LIFO income statements), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.

Four general categories for quantitative credit analysis:

  • Scale and diversification: purchasing power from scale and product/geographic diversification
  • Tolerance for leverage:
    • Retained cash flow (RCF)/total debt
    • (RCF – capex)/total debt
    • Total debt/EBITDA
    • (EBITDA – capex)/interest
    • EBITDA/interest is the most well known and used formula of the four
  • Operational efficiency leads to lower costs and higher margins
    • EBITDA margin
    • Operating margin
  • Margin stability is measured through average % change in EBITDA margin

Remember the basic screens for different equity strategies, i.e. growth versus value investing, and the limitations of back-testing.

We are going to skip over some topics and begin our coverage of Equity Investments next week. The topic area is covered in two study sessions and will become increasingly important in the next two exams. Building a good base of knowledge from Level 1 material is absolutely critical to doing well on the other exams.

Only a few months left to the December exam. If you haven’t already, assess how you are doing with a mock exam or some practice problems over the material you have covered. If you are not through at least a few study sessions or are not retaining much of the information, you may need to step up your schedule. Stay strong, we’ll get there.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Balance Sheet

Study Session 9 is really your first look into the detail in the financial statements. There are four readings, covering inventories, income taxes, non-current liabilities and non-current assets. The material may seem a little boring at times and is largely a review of accounting issues. Resist the urge to just go through the motions and memorize enough to pass the test on these topics, here and in the other readings on the financial statement accounts. Learning the intricacies within the individual line items in the financial statements is your life as an analyst and really separates the good from the great.

It may be easy to fall into a trance-like state while reading through the material. You really need to stop every once in a while to think back on what you’ve read and review the important points.

Inventories

The material revolves around the choices for inventory accounting (FIFO, LIFO, Weighted Average, and Specific ID). You absolutely must know the FIFO AND LIFO concepts as well as how the choice affects ratios and the income statement. You will need this going into the CFA level 2 exam so don’t ignore it.

FIFO expenses the first items purchased for cost of goods sold, which are usually cheaper given inflation. This will lead to higher earnings from the lower expense. Ending inventory, working capital, shareholders’ equity, earnings, current ratio, ROA, ROE and the profit margin are usually higher using FIFO accounting. The advantage of FIFO is that the ending inventory will represent current replacement costs.

LIFO expenses newer inventory first so ending inventory will usually be lower in an environment of increasing prices. Understand what happens in an inventory liquidation and what it means for taxes, cash flow and earnings. After-tax cash flow, debt-to-equity, and asset turnover are usually higher under LIFO accounting. The advantage of LIFO is that it better matches current costs in goods sold with revenues.

The weighted average costing method is fairly straight forward and just the total cost of units available for sale divided by the total number of units available for sale in the period. It is not quite as commonly used and the Institute does not spend nearly as much time on it as the other two methods. The advantage of average costing is that it smoothes any price changes.

Understand how to convert LIFO to FIFO statements. Add the ending LIFO reserve to inventory. Subtract the change in LIFO reserve from the COGS for FIFO cost of goods sold. Adjust the LIFO net profit by the change in LIFO reserve and the tax rate for the FIFO net profit.

For the exam, you need to understand how the inventory costing methods result in different valuations in other accounts (i.e. gross/operating/net profits, ending inventory, cost of goods, taxes). The table below shows the costing method affects in a (normal) rising price environment. You may be asked how this would differ when prices are falling which would mean that the opposite would happen. More important that memorizing the table is understanding what is happening.

A table with LIFO and FIFO across the top and all the relevant ratios/financial statement line items down the side makes it easier to see how the two methods can cause differences in your analysis. Rather than just writing higher or lower, understand why the effect happens (i.e. shareholders’ equity is usually higher with FIFO because earnings and inventories are higher).

Long-lived Assets

Much of the reading revolves around the capitalizing/expensing debate. Understand the rules for capitalizing and how/why managers might want to bend them.

On acquisition, all tangible assets (physical assets) are recorded at cost on the balance sheet. This is capitalization because the company creates a capital asset that will be used in the business. It appears as an increase in the asset and shareholder’s equity (balance sheet) and a cash outflow in investing (Statement Cash Flows). The company will then depreciate the value of the asset by expensing a certain amount on the income statement each quarter and increasing the accumulated depreciation account on the balance sheet.

The company may also choose to expense an asset if its usefulness is used entirely in the current period. This means no change on the balance sheet and higher expenses on the income statement. Since this results in lower net income (in the current period) and lower assets, management may choose to capitalize an asset when it can.

Your job as an analyst will be to decide if the decision was appropriate and adjust the financial statements if necessary. The material on the adjustments is important and you should remember how to adjust the interest coverage ratio (add depreciation expense to EBIT and the capitalized interest to interest expense) and the net profit margin.

You may also want to adjust the statements for capitalized interest by: add capitalized interest back to interest expense, reclassify capitalized interest from investing to operations on the cash flow statement, remove capitalized interest from depreciation expense.

Understand how the financial statement accounts and ratios differ under capitalizing or expensing. A table makes it easy to remember with capitalization on one side and expensing on the other. Return on equity, ROA, profit margin, pretax cash from operations, earnings, and shareholders’ equity will be higher under capitalization. Cash from investing, asset turnover, and debt-to-equity will be higher under expensing.

Remember the difference and how to calculate the methods of depreciation: straight-line, accelerated, and units-of-production and be able to estimate the age of fixed assets.

Straight-line depreciation is relatively easy and just the original cost minus salvage value, divided by useful life. The biggest hurdle is remembering to reduce by salvage value because many candidates forget the step.

Accelerated depreciation for each year is = (2/asset life) multiplied by the year’s beginning book value of the asset. The method books higher depreciation expense earlier in the asset life.

Debt-to-equity and asset turnover will be higher under an accelerated method of depreciation while ROE, ROA, profit margin, shareholders’ equity, and earnings are higher under straight-line.

The units-of-production method is = (number of units produced/number of total units asset will produce over useful life) times the cost minus salvage value.

Intangible assets are those like patents and goodwill that do not have a physical nature. The most important material here is the difference between IFRS and GAAP in the recognization and accounting for intangible assets. There are separate rules for an internally-generated asset (i.e. through R&D) and an acquired asset. Again, a table with IFRS and GAAP next to each other makes it easiest to compare and remember the material.

Income Taxes

You will need to know the difference between accounting profit and taxable income and how to calculate deferred tax assets and liabilities. A deferred tax liability is taxes that will be paid in the future because the company reported lower taxable income than profits, while a DTA is taxes that will be saved in the future. The material can be a little confusing so you may need to spend a little extra time.

On these more difficult concepts, I like to look for a YouTube video that may help explain things. If you are a visual learner like me, it may help to see the material from a different perspective. Allen Mursau provides a good overview of deferred taxes at https://www.youtube.com/watch?v=45PARid_erY

Understand the concept behind temporary and permanent differences. Tax-exempt interest, allowable tax credits and life insurance premiums are the usual examples for permanent differences.

Be able to determine the income tax expense under the liability method: Taxes payable + change in DTL – Changes in DTA net of valuation allowance.

Non-Current Liabilities

You need to be able to work through the calculation for interest expense, coupon payment and the ending carrying value of a bond. It can be a pain at first isn’t too difficult once you understand what is happening.

The interest expense is just the ending carrying value times the market rate times ½ for semiannual bonds. Reduce this by the interest payment (face value * coupon rate*1/2) for the change in the liability. The prior ending carrying value plus the change in liability is your new carrying value.

Understand how a change in interest rates affects the market value of debt and economic gains. An increase in rates will decrease the value of debt and lead to an economic gain.

Remember the five main debt covenants: limitations on asset disposal, restrictions on debt issuance, limits on use of borrowed funds, collateral maintenance, and dividend restrictions.

Study session ten in the CFA Level 1 curriculum concludes the material on FSA with reporting quality and some applications.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Cash Flows and Financial Analysis

We covered the first half of study session eight last week with a review of the Balance Sheet and Income Statement. We wrap up our review this week with the Statement of Cash Flows and Financial Analysis Techniques.

Cash Flows are an Analyst’s Best Friend

The Statement of Cash Flows is where you will likely spend much of your time in your first years as an analyst. This reconciliation of cash in and out of a business over a period can be constructed completely from the other two statements. It is also less easily manipulated than the income statement and provides a powerful check against aggressive accounting assumptions on the income statement.

There are two methods of constructing the Statement of Cash Flows, direct and indirect. While it may be tempting to pick one method of cash flow statement construction, you absolutely must know both methods. There is no better practice to understand how the company operates, i.e. how the company uses assets, liabilities and income to generate cash for equity holders. Knowing the power of cash flows over reported income will make you a superb analyst.

Cash versus Accrual Accounting

While the other two statements follow an accrual method of matching expenses and revenues made during the period, the Statement of Cash Flows shows the cash receipts and payments during the period. It is a reconciling statement in the company’s cash and cash equivalents during the period. Because it shows actual inflows and outflows, it is much more difficult to manipulate by management and widely used by analysts.

The general structure for the statement is that,

  • Change in Cash = Cash from operations (CFO) + Cash from Investing (CFI) + Cash from Financing (CFF) + any effects of exchange rates

There is a lot of material here but the first thing you need to master is distinguishing between a cash outflow and a cash inflow. It is all about whether an account is a source of cash or a use of cash. Once you’ve got that understood, everything else is intuitive and more easily understood.

Assets are sources of cash, if you see a decrease in an asset (on the balance sheet) that means the company converted that asset to cash, i.e. cash inflow.

Liabilities are a use of cash, a decrease in a liability account means the company used cash to pay for that decrease, i.e. cash outflow.

Cash Flow from Operations

Besides cash from sales of goods or services, an important part of CFO is the adjustments from items on the balance sheet and income statement. These adjustments happen because of the accounting difference between accrual-based and cash accounting.

  • Depreciation for assets, expensed on the income statement as a use of a capital asset, is not a use of cash so must be added back to net income. This account is extremely important for a lot of capital-intensive sectors like energy and real estate. The company’s continual investment in new equipment or depreciable assets will be an important check against depreciation.
  • Change in operating assets and liabilities that have already been accounted for on the balance sheet but had not yet settled in cash, i.e. accounts receivable, inventories, accounts payable, etc. This is the company’s ‘working capital’ and is important in analyzing the true efficiency of operations. These are all short-term assets and liabilities used in the day-to-day operation of the enterprise.
  • One confusing aspect of the statement is remembering how dividends and interest are shown. Dividends received and interest received and paid are shown as cash flow from operations, while dividends paid are shown as financing.

Cash Flow from Investing

While operating assets and liabilities, or working capital, is shown as cash flow from operations, cash flows for the purchase or sale of long-term assets is shown as investing. This makes intuitive sense if you think of these assets as an investment in long-term production. Items include fixed assets, long-term investments and business acquisitions or divestitures.

Cash Flow from Financing

Financing includes borrowing or repaying debt principal but not interest which is taken as a cost of operations and shown under CFO. Similarly, since equity capital (common and preferred stock) is raised as a financing vehicle, issuing or repurchasing shares and paying dividends is shown as CFF.

Converting the Statement to Direct Method

Most firms use the indirect method to prepare cash flows so the most common need is to convert the statement to the direct method. Firms reporting under the direct method must also present a reconciliation to the indirect method ( U.S. GAAP). The direct method details the firm’s operating cash receipts and payments from customers, suppliers, employees, etc. while removing a lot of the effects of accrual accounting. CFI and CFF are the same for both methods.

You must be able to arrive at CFO using the direct method.

The general formula for the direct method is:

Net Cash from Operations =
Cash Collected from Customers
– Cash paid to suppliers
– Cash paid to employees
– Cash paid for operating expenses
– Cash paid for interest
+ Cash received from dividends and interest

Start with Revenues
+/- change in unearned revenue
+/- Change in Accounts Receivable
= Cash collected from customers

Cost of goods sold
+/- change in inventory
+/- change in accounts payable
= Cash paid to suppliers

Salaries and wages expense
+/- change in wages payable
= Cash paid to employees

Other operating expenses
+/- change in prepaid expenses
+/- change in accrued liabilities
= Cash paid for other operating expenses

Interest expense
+/- change in interest payable
= Cash paid for interest

Dividend and interest income
+beginning interest receivable
– Ending interest receivable
= Cash received from dividends and interest

The Indirect Method

Since most statements use this method, you will not usually have to do the work but it is important to know how to put it together. The method starts with net income and adjusts for cash and non-cash items.

Net Income
+ Non-cash charges (depreciation, amortization, depletion expense)
+ increases in current operating liabilities
+ decreases in current operating assets
+ increases in deferred income tax liability
– increases in current operating assets
– decreases in current operating liabilities
– decreases in deferred tax liability

+ any losses on investing or financing activities (loss on sale or write-downs, loss on debt retirement)
– any gains on investing or financing activities

= Net cash from operations

Free Cash Flow

Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exam, especially at level II. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been accountable. Basically, it is the extra cash available to owners (of debt or equity) after the company’s future operations have been funded.

Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense

Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing

  • Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
  • Understand how to arrive at FCFE or FCFF with CFO
  • FCFF = CFO + INT (1-t) – invest fixed capital
  • FCFE= CFO – invest fixed capital +/- net borrowing

There are a few performance and coverage ratios you should remember as well. Most are relatively simple, just the CFO over an account from one of the other statements. Remember that any account from the balance sheet must be averaged between the beginning and ending value since the balance sheet is a point-in-time estimate rather than activity over the period.

GAAP and IFRS Differences

The difference in cash flow reporting for GAAP and IFRS are extremely testable so you must remember them for the exam. The material is relatively brief and lends itself easily to a flash card.

Interest paid – can be classified as operating or financing cash flows in IFRS but only as operating cash flows under GAAP.

Interest and dividends received – can be classified as operating or investing cash flows under IFRS but only as operating cash flows under GAAP.

Dividends paid – can be classified as operating or financing cash flows under IFRS but only as financing cash flows under GAAP.

Companies reporting under IFRS need to separate their income tax account if possible under operating, investing or financing while all income taxes are reported under operating cash flows in GAAP.

The direct method is preferred under both IFRS and GAAP but the indirect method may also be used. Under GAAP, a company must also provide a reconciliation to the indirect method if the direct method is used in the statements.

Financial Analysis Techniques

The introductory material on ratios, common-size techniques, regression analysis and the use of graphs is probably secondary to actually understanding the formulas that follow and what they mean. Understand the basic concept behind the broad range of techniques and any advantages/limitations to each.

There are an immense number of formulas shown, I counted more than 50 in the FinQuiz study notes including multiple ways to get at the same idea. The likelihood of seeing any individual formula on the exam is relatively small so I would spend more time on the bigger picture and the three financial statements. Make a flash card for each formula and run through them until you are familiar with the concept and inputs to each formula. Once you’ve got a particular formula, put the card in your secondary pile which you may only need to review every month or so. This should be enough to reproduce it on the exam if needed.

Study Session 9 digs deeper into the balance sheet with readings on inventories, income taxes, and non-current assets and liabilities.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: Financial Statements

Study session eight in the curriculum is your first real look at the three financial statements and some techniques in analysis. I won’t say that the material absolutely must be a pleasure but this is going to be a big part of your job as an analyst. If you are not the slightest bit interested in dissecting the financial statements and analyzing what you find…you might want to consider another career path.

The study session is a long one and important enough to take a little extra time to work through. We’ll cover the first two readings this week and then finish up next week.

It’s hard to distinguish any significantly important material in the curriculum covering the financial statements because it is all extremely important.

  • Understand each individual line item that shows up on the statements,
  • which accounts can be manipulated by management and how,
  • how each account is valued,
  • which accounts are used in ratio and other financial analysis, and
  • how the three financial statements are related to each other.

Understanding Income Statements

The income statement measures the company’s performance over a period of time. The main point is that revenues and related expenses are matched during the period in which they occur, i.e. accrual accounting. This is supposed to give a better measure of performance than a cash accounting because cash does not always come in at the same time as the work is done. The problem is that management often has a strong incentive to manipulate the revenues, expenses and other items to show earnings in a different light.

It’s important to understand the basic structure of the statement and what each line item represents:

  • Net Sales is gross revenue minus any allowances for returns
  • Cost of goods sold is really what it sounds like and is the inventory cost, here it is important to understand inventory accounting procedures like LIFO, FIFO, or average cost to understand how management is expensing it
  • Gross Profit is the difference between net revenue and COGS (also used to find Gross Margin) and is your first measure of profitability
  • Selling, General & Administrative is all direct and indirect expenses that can be linked to operations (salaries, rent, utilities, marketing, pretty much everything that is not associated with the cost of inventory itself)
  • Operating income (profit) is the result of operations and your second measure of profitability. This is also sometimes referred to as EBIT or earnings before interest and taxes. (profit margin = operating income/ net revenue)
  • Interest expense is just the interest on debt for the period
  • Nonrecurring items- discussed below
  • Provision for income taxes represents the estimated tax liability and gives an indication of the effective tax rate
  • Net income is your final measure of profitability (net margin = net income/net revenue)

Firms with a controlling interest in a subsidiary will also report the amount of net income from the subsidiary on their own income statement. You will see much more detail on how and when this income is consolidated on the parent company’s statements in Level 2. For the first exam, just remember the basic definitions for minority interest and consolidation.

A theme throughout the curriculum is the preference for conservative accounting principles, as opposed to aggressive practices. Conservative principles are those that take the ‘safe’ bet when recognizing revenues or expenses (and usually less favorable to short-term reporting). The idea is that if management is taking a conservative approach on some accounting practices, they are less likely to be trying to manipulate the data to show the financials in a better light.

There is quite a bit of information on revenue recognition. Start with remembering the ‘criteria’ for recognizing different types of revenue and the ‘procedural steps’ for recognition. This kind of list material is easily testable.

Understand how to calculate the two methods for revenue recognition of long-term projects and the SEC’s four criteria for revenue recognition:

  • Legitimate arrangement between buyer and seller
  • Delivered or rendered the product or service
  • Price is or can be determined
  • The seller can be reasonably assured of collection

Revenue recognition for long-term contracts is particularly important for the idea of accrual accounting, i.e. matching revenue with appropriate expenses in the current period. Remember the steps to the different methods:

  • Percentage of completion

    • Percent complete = total costs to date/total expected costs
    • Recognizable revenue total = estimated total revenue * percent complete
    • Current period revenue = Recognizable revenue total – prior revenue recognized
  • When the expenses and sales for a project cannot be measured until completion, U.S. GAAP allows the completed-contract method. All billings and expenses are capitalized on the balance sheet until the project is completed then everything is moved to the income statement.
  • Percentage of completion method is more aggressive because revenues are booked immediately even if they will not actually be received until later. It is also subject to considerable assumptions and shows smoother earnings.

The material on LIFO and FIFO is extremely important and you will need this introductory knowledge for detailed analysis in the Level 2 exam.

  • FIFO expenses the oldest inventory on the income statement first (first-in, first out). This means that ending inventory (the materials still held for production after the current period) better matches current replacement costs.
  • LIFO expenses the newest inventory on the income statement first (last-in, first-out). The method is permitted under U.S. GAAP but not IFRS. It better matches current costs with revenues.
  • Weighted Average Costs is not used as much in the curriculum as LIFO or FIFO but you still need to know how it is calculated and how it relates to the other two methods.

** Understand the implication of these three costing methods on Net Income, Ending Inventory and Cost of Goods Sold in two scenarios (rising prices and falling prices).

  • FIFO reports the highest net income and ending inventory but the lowest cost of goods in an environment of rising prices. This is because older (cheaper) inventory is expensed first.
  • LIFO reports the highest net income and ending inventory but the lowest cost of goods in an environment of falling prices. This is because newer (cheaper) inventory is expensed first.
  • Weighted Average Cost always reports NI, EI and cost of goods in the middle of these two in both pricing environments

Depreciation is another topic where you will need to master the introductory information to do well on the Level 2 exam. The three methods are easily testable because they lend themselves well to quick calculations.

  • Straight line depreciation spreads the value out over the useful life = (cost – residual value)/useful life
  • Accelerated depreciation takes higher depreciation charge earlier in the equipment’s life = (2/remaining       useful life)*(cost – accumulated depreciation)
  • Units of production matches the depreciation with production

Nonrecurring items that are unusual or infrequent (but not both) are reported as part of earnings from continuing operations and are often a way for management to take large expenses up front instead of in the future. Examples are: restructuring costs, asset impairment charges, gains or losses on sale of long-lived assets.

Those nonrecurring items that are unusual and infrequent (extraordinary) or discontinued operations are reported net of taxes below income from continued operations. Because these are so out of the ordinary, analysts do not normally consider them against performance. As with those nonrecurring items included in continuing operations, analysts must decide whether they are appropriately reported.

Remember that some items are not reported on the income statement but go “direct to equity” as other comprehensive income. The easiest way to remember these is by the PUFE acronym for:

  • Pensions or additional minimum pension liability
  • Unrealized gains or losses on available for sale securities
  • Foreign currency exchange translations on hedging
  • Effective portion of cash flow hedges

You are not asked to do much with the Statement of Comprehensive Income at level I but just understand the basic relationship and what each of the four items represents.

Understand which changes to accounting standards must be reported retrospectively (changes to accounting principles) and which must be treated prospectively with no adjustments to prior periods (changes to estimates) and that corrections of prior period errors require a restatement of financial statements.

Be able to calculate earnings per share for both a simple (just NI minus preferred dividends over weighted average common shares) and complex capital structure (basic EPS adjusted for After-tax interest on convertible and common share adjustments for assumed conversions).

Understanding Balance Sheets

Unlike the other two statements, the balance sheet is a ‘snapshot’ in time. The figures reflect the state of accounts at that moment, the last day of the quarter or year. The other two statements represent activity over the period. For this reason, and this is very important, when you perform ratio analysis comparing numbers across the statements you will take an average of the beginning and ending figures for balance sheet accounts. For example, the cash debt coverage is cash-flow from operations divided by average total debt from beginning and ending balance sheet date.

You’re going to get tired of people saying, “Assets = Liabilities + Equities.” This is the basic balance sheet equation and around which much of the material will revolve around. Understand what it shows when you change around the equation (i.e. A-L = E) and you’ll get the importance of the concept.

Account Valuations

One of the most important topics on the statement is valuation. Some accounts are shown at historical or amortized price, while others are shown at fair (market) value. Obviously this makes a big difference in overall valuation and when comparing numbers. Further, analysts often will adjust the numbers to arrive at a number they feel is more realistic or comparable. You aren’t asked to do this but just to understand where it might be needed and why. The definitions below will each describe the method of valuation for the account.

Assets

Assets represent a future probable economic benefit and could be accumulated items, amounts spent but not yet expensed (matched with revenues) or amounts earned but not yet received (accounts receivable).

Current assets are the most liquid and are accumulated or planned to be used in the ‘current’ operating period. Normally recorded at fair market value.

Cash or cash equivalents- is usually short-term money market, CDs, commercial paper or treasuries that can be converted to cash quickly. This is used in all your liquidity ratios and is (duh) valued at market.

Accounts receivable– Sales made on credit but not collected, usually offset by an allowance for uncollectable (estimated) but shown net realizable (fair) value. Trends in AR are an important indication of performance and estimates.

Inventories- A key item and one you’ll spend a lot of time on through the curriculum. Reported at lower of cost or market on the balance sheet but estimated through different practices (LIFO, FIFO, or average). Could be broken down into three sub-accounts: raw materials, work-in-process, and finished goods.

Prepaid expenses– Where the company has paid in advance for a service or product, i.e. insurance and rent. Valued at market with an adjustment when they are expensed through the income statement.

Long-term assets have a useful life of more than a year (or operating cycle) and are usually not going to be sold to customers. These accounts are usually recorded at cost and then depreciated or amortized over the estimated life.

Property, Plant, & Equipment – valued at cost and depreciated over its estimated useful life, shown as net. These are also referred to as ‘tangible’ assets because they generally have physical substance and are easily counted.

Goodwill & other intangibles– Goodwill is the amount paid for acquisitions above their market value. It is basically a premium paid for things like brand and proprietary technology. It is recorded at cost and tested annually for impairment, which is an estimation of the value that no longer exists.

Liabilities

Liabilities are future probable sacrifices from obligations or transactions and could be: amounts received but not earned yet as revenue, amounts received that must be repaid or amounts expensed on the income statement but not yet paid (accounts payable, accruals, etc).

Current liabilities are those that will be paid or settled in the ‘current’ operating cycle.

Accounts Payable– suppliers have sold something to the company on credit that must be repaid. As with AR, you’ll look for trends in this to see that the company is not taking longer to pay. Valued at market.

Accrued liabilities– Those items expensed in the current period but that will not be paid until the next period, kind of a carry-over effect of timing, i.e. wages and interest owed but not paid yet. Valued at market.

Short-term debt- includes lines of credit and notes with an original maturity of less than a year (negotiated debt).

Current portion of long-term debt – principal portion of long-term notes including any capital lease obligations.

Unearned revenue- sales collected in advance but not yet earned so they sit here until delivered or performed. Settled as revenue on the income statement instead of through a cash adjustment.

Long-term liabilities is often a single line item for debt but can also be broken out into items like: bonds and notes payable, long-term lease obligations, deferred taxes and pension liabilities.

Stockholder’s Equity

Equity is the residual after assets and liabilities and that which is due the owners of the company. It includes: capital contributed by owners through stock, recognized on the income statement but not yet paid out to owners (retained earnings) and adjustments to assets or liabilities that did not go through the income statement (see other comprehensive income in prior post).

Contributed capital– is supplied by stockholders and broken into common, preferred and additional paid-in-capital.

Minority interest – This is the cumulative, noncontrolling ownership held in other companies.

Retained earnings– accumulated net income due to owners but not yet paid out.

Treasury stock – amount paid to repurchase company stock usually shown as a negative number because it decreases equity.

There differences between IFRS and U.S. GAAP are probably the most important here on the balance sheet and you should try to remember the list material for the exam. Make out a flash card for each line item where valuation or reporting differ between the two (Inventories, PP&E, Intangible assets, goodwill). Place U.S. GAAP standards on one half with IFRS next to it to quickly compare the differences.

The three types of financial assets (Held-to-Maturity, Held-for-Trading, Available-for-Sale) are important to understand. Remember the criteria for each, how it is valued on the balance sheet and how unrealized gains are reported.

Deferred tax assets and liabilities will also be a big section on the next exam but you only need the basic definition for the first exam.

That is a ton of information for a blog post and only the high-level stuff you need to know about financial statements. Take the extra time on these next few study sessions and master the material. We will wrap up SS8 next week with a review of the Statement of Cash Flows and an introduction to Financial Analysis Techniques.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review: FRA and the Most Important Topic Area

Study session seven in the CFA Level 1 curriculum begins your study into Financial Reporting & Analysis, arguably the most important topic across the curriculum and your career. The session includes three readings covering an introduction, the mechanics of FRA and the two international accounting standards. It is all basic material and probably repeat for those with a finance background.

Financial Statement Analysis

This is really basic material and fairly intuitive. If you’ve got a background in finance, I would skim it while checking off the Learning Outcome Statements to make sure you have the general idea. There’s no calculations and you’re more likely to get questions from other sections of FRA.

Understand why different entities may have different uses for the statements; i.e. creditors, analysts and investors.

The balance sheet is a point in time measure of the firms assets, liabilities and equity capital. The numbers presented are as of a certain date. This is important because the other statements are presented for activity in the period. For many of the ratios, you will be using an average of the beginning and ending value to get a better representation of the account over the period. Another important thing to remember is that values on the balance sheet do not necessarily reflect fair market value. You will spend a lot of time learning how each line item is recorded and held on the books.

The income statement is a report of the firm’s operations over the period. How many sales they recorded and what it cost to make those sales. The most important thing to remember here is that sales do not mean cash flow. Understand the concept of the accrual method of accounting and how revenues and expenses are matched.

The statement of cash flows is a reconciliation of the other two accounts and reports how the firm’s cash changed over the period. You will be shown how to construct the statement two different ways, direct and indirect. Resist the temptation to just learn one way and hope that you don’t need to use the other. Understanding how cash payments and receipts are reported is one of the best ways to understand the company and will pay off big time in your analysis.

Beyond the three statements, the curriculum constantly emphasizes the importance of the Notes and Supplementary Information. The real detail in a company’s statements are buried within the notes so understand that you need to check there throughout your analysis. The curriculum spends some time on Other Comprehensive Income but only the basic need behind the statement.

Understand what an audit is and what kind of internal controls the company has, i.e. an independent board that is available to the auditors. Remember the basic language given in the four types of auditor reports:

  • Unqualified opinion – the most common and indicates no material misstatements and in accordance with GAAP.
  • Qualified opinion – some exceptions or limitations to accounting standards, possibly concerns to assumptions or valuations of certain items.
  • Adverse opinion – Not presented fairly or are materially misstated or not in accordance with GAAP
  • Disclaimer of opinion – the auditor is unable to issue an opinion

Understand that there are also other sources of information including: interim reports, proxy statements, the company’s website and press releases.

Financial Reporting Mechanics

The reading covers the standard conventions for developing the financial statements and is a great primer for deeper study. If you do not have a background in accounting or finance, this reading is a lifesaver because it will help get you up to speed.

The balance sheet is broken into current and non-current assets, current and non-current liabilities, and stockholder’s equity. Assets, whether current or not, are the resources the company uses in its operations. Current assets are those that the company plans to use or convert to cash within a year. Long-term assets are longer-lived and include PP&E, intangible assets and goodwill.

Liabilities are creditors’ claims on assets, and are drawn against assets to find the amount left to the owners. The curriculum does not spend quite as much time with Owner’s Equity. Just remember that it is contributed capital plus retained earnings and understand the basics behind the accounts.

Understand the difference between operating, investing and financing activities. This is the key to analyzing how the business works. Operating activities are the core business including sales and how those sales are made. Investing activities relate to the acquisition of long-term assets and investments and help to generate more operations in the future. Financing activities relate to the firm’s capital transactions involving equity or debt.

As part of learning the cash flow statement, remember the difference between a source of cash and a use of cash, and how it relates to the other statements. An increase in liabilities or equity or a decrease in assets is a source of cash because either an asset is being converted to cash or a liab/equity is being accrued in exchange for cash now. On the other hand, an increase in assets or a decrease in liab/equity is a use of cash. Buying an asset or paying off a liability/equity account decreases cash.

The Accounting Process is about a year’s worth of accounting classes packed into one reading. It is general information and you shouldn’t have too much trouble understanding it. While important, it’s secondary to the financial statement material.

The section on Accruals and Valuation Adjustments is very important and core to your job. As an analyst, you need to see through the ways management adjust accounts and be able to arrive at a fair value. Understand unearned (deferred) revenue and prepaid expenses and the assumptions/adjustments made for both in the income statement.

Lastly, understand how the three statements are related. The income statement flows through to the balance sheet through retained earnings. The cash flow statement relates to the balance sheet through change in cash. Additionally, there are many accounts that are linked (i.e. depreciation, working capital).

Financial Reporting Standards

While you will need to understand how the statements are reported differently under IFRS and GAAP, a lot of this background information is secondary to the mechanics. Understand the relationship between each framework and the private sector organizations that establish rules (FASB and IASB) and the difference in framework between IFRS and GAAP.

Knowing some of the forms will be necessary in your professional life, even if you don’t see a specific question on the exam. 10-K is the annual report to the SEC while 10-Q is a quarterly report. Material events outside of the quarterly or annual reports are required in an 8-K form. Forms 3, 4 and 5 are required to report changes in ownership.

Remember, IFRS does not permit LIFO as an inventory costing method and uses a single-step method for impairment rather than the two-step method used in GAAP. IFRS also requires capitalization of development costs when certain criteria are met.

An important difference between GAAP and IFRS is the difference between a principles-based method, providing a broad reporting framework and more judgment, and a rules-based method which provides specific rules for each transaction and requires less judgment.

Study session eight gives you your first glimpse into the financial statements and is extremely important. Be ready to spend a lot of time and master the material or you will not only have problems on the first exam, will need to relearn the material for the other two exams.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: December 22, 2016 at 8:01 am


CFA Level 1 Review: Quant Methods, Building Blocks going Forward

This week we begin our review of some of the most important topic areas for the Level 1 exam. We may not cover every study session before the December exam but we will hit the most important areas and try to make sure you get all the points possible.

You’ll notice that we are skipping over one of the most important topic areas in the exam, Ethics and Professional Standards. If you’ve been following the blog, you know how important this topic is but also that it does not change much from year to year. We’ve covered the Ethics section several times and you can find the most recent post by clicking here. Remember, don’t just read through the material on Ethics and the Standards. You really need to be practicing those end-of-chapter and test bank problems to get a feel for how it will be tested on the exam.

Quantitative Methods: Lower points but absolutely essential

The Quant Methods topic area may represent one of the secondary topics by points on the first exam, only accounting for 12% of your total score, but the material is absolutely critical to your success across the exams and as a professional. You may be able to get through the exams and your career with just a basic understanding of other topics (i.e. derivatives) but try being an analyst without mastering discounted cash flows and statistical concepts and it will be a short career.

Unfortunately, the section is avoided by many candidates. As someone who never really liked math in school, I can relate to the desire to avoid quant methods. Realize as I did though, you are in an analytical field and you need to embrace mathematics. Trust me, math can actually be enjoyable and you can learn to love it. Spend a little time and you will be amazed at how quickly you start understanding more complex concepts. A little effort to break an old perspective will go a long way and will help you immensely.

Quant methods are covered in two study sessions in the Level 1 exam, Basic Concepts and Application, with four readings in each study session. The first study session will be repeat material for anyone with an educational background in finance and should be fairly easy to understand for just about anyone else. Study Session 3 is a little more difficult but still manageable. Of the readings, I would say all but technical analysis are equally important and testable. Ideas like time value of money, probability and quant testing are fundamental to the curriculum and you’ll need to be able to do the math in just about every other topic area.

Make sure you have a basic understanding of technical analysis but it is probably the least important. The Institute has never really put much faith in technical analysis so you will likely only see basic questions on the exam, if at all.

Time Value of Money

The most important thing here is be able to use your calculator to solve for any one of the missing variables. Note that the Institute usually keeps problems within the realm of possible reality so if you get an answer that seems extremely high or low then you need to go back through the calculation to make sure you did it correctly.

Make sure you divide the annual rate by the number of times it is compounded within your formula. (i.e. $100 at 8% compounded quarterly for two years = $100 (1.02)8 is different than simply $100 (1.08)2

Most calculators calculate cash flows as an ordinary annuity, where payments come at the end of the period. Make sure you set the “begin” key for any annuity due problems where payments come at the beginning of the period. Also, remember that the payment and present value inputs will have opposite signs (i.e. since the payment represents an outflow use a negative sign).

**Important** Get in the habit of clearing out your calculator before or after you work a problem. It is as easy as two quick keystrokes (2nd and Clr Wk) and can save you points on the test.

The future value of cash flows is
FVN=PV(1+r)N

i.e. if your savings account earns interest at a 5% rate and you have $100 deposited, how much will it be worth in 20 years?

FV20=$100(1+.05)20
=$265.33

This is a fairly basic calculation with no payments and you’re more likely to see something more difficult on the exam. It is relatively easy to work through but learn to do it on your time value buttons,

PV = 100
I/Y = 5
PMT = 0
N = 20
CPT –>FV

Whether you input the present value as a negative or not doesn’t matter much here since there are no payments. For other problems, just remember that outflows (deposits and payments into an investment or account) should be negative while inflows (money you receive or value) should be positive. One of the cash flows must be negative (outflow).

The future value of a series of cash flows is only slightly more difficult but easily understandable if you think of each payment as a single future value calculation. Don’t forget the note on changing your calculator for an annuity due.

Example: The same savings account as above has $100 deposited but you plan on depositing an additional $100 per year at the end of the year. What will the balance be at the end of 20 years?

PV= -100
PMT = -100
N = 20
I/Y = 5
CPT–>FV
FV = $3,333

Make sure you understand how to solve for each variable in the equation when given the other variables.

Note: I set my calculator to four decimal places which is usually more than you will need for the exam.

Discounted Cash Flow

This is arguably the most important reading in the study session and you will see the concepts across all three exams.The first section covers NPV and IRR which are really two sides of the same coin. NPV is the value today of the series of cash flows at a discount rate. IRR is the discount rate at which NPV is zero. Either one can be used in a budgeting decision. As with much of the material, understand the situations where each is more appropriate and the strengths/weaknesses of each concept.

Both NPV and IRR are found easily with the calculator. Remember that a key assumption of IRR is that cash flows are reinvested at the rate, which may not be realistic. Also, if there are multiple cash outflows, there will be multiple IRRs or none at all. There may be a conflict between NPV and IRR when projects are mutually exclusive or when there are multiple cash outflows. In this case, NPV is preferred.

Using the calculator is relatively easy,
The initial project cost or investment is a negative (outflow) as CF0
CO1 through x are the stream of cash flows and entered as a positive (inflow)
If cash flows are an equal amount, you can enter them as F (frequency)
Press the NPV button and enter the interest rate
Down arrow
CPT–> NPV
For IRR, just press the IRR button and CPT

Time-weighted returns measure the rate of growth over a defined period between cash flows. It should be used when the portfolio manager does not control cash in and out of the account (as is usually the case). Money-weighted returns can be done easily using the cash flow function on your calculator but may not be as applicable unless you have discretion on cash flows.

Know the difference and how to calculate the material in money market yields section (i.e. money market yield, bond equivalent yield, and HPY). These are good formulas for flash cards if you’re having problems.

Statistical Concepts and Market Returns

As with much of the quant methods material, you should start with an understanding of the basic concepts before worrying too much about the different variations. It is much more important to master the concept of standard deviation than to work through the material too quickly trying to get a vague idea of everything.

Geometric and Arithemetic averages are important. The arithmetic mean is simply the sum of observations divided by the number of observances while the geometric mean is the compound return by taking the nth root of the product.

The material on measures of dispersion is extremely important and will feed into the concept of risk. Even though you will be able to calculate variance and standard deviation on your calculator, spend the time to learn the formulas.

The Sharpe ratio is a key concept throughout the curriculum and you need to understand what it means as well as how to calculate it. It measures the excess return on an investment or portfolio and can be used to rank opportunities. You will use iterations of this formula in many other concepts (i.e. Roy’s Safety First). The drawback is that, since it uses standard deviation as a measure of risk, it is most applicable for symmetric distributions and may overstate risk-adjusted performance.

Understand that the mean, median and mode are the same in a normal distribution but different with skewness. Don’t worry too much about calculating kurtosis or skewness, just understand the their implication. (i.e. how it affects dispersion and returns)

Probability Concepts

The most important material here is covariance, correlation and being able to do the calculations for expected value, variance and standard deviation for a two-asset portfolio. The formulas can get kind of long but they are pretty basic. This is the material that will be used most through the other levels of the exams as well.

Remember, the expected return is just the weights of each asset times their respective expected returns.

Correlation between two assets is the covariance divided by the product of the two standard deviations.
Correlation = COV(X,Y) / STDev (x) STDev (y)

Correlation ranges from -1 (perfect negative relationship) and +1 (perfect positive relationship).

Common Probability Distributions

Most of the introductory material here is fairly unimportant as it isn’t used much in other parts of the curriculum. The binomial distribution is a little more important because it relates to some of the derivatives material. The normal distribution is really where you want to spend your time.

Remember that 90% of the distribution will be between 1.65 standard deviations, 95% within 1.96 deviations and 99% within 2.58 deviations. You will be given a z-table but need to know the formula and the applicable number of standard deviations. You need to pay attention to the question and look for which part of the curve you are being asked to measure. Do you need an interval around the mean or just one side? All the stuff around the z-score (the formula and finding probabilities) is fairly basic so spend some time and master it.

The information covering Monte Carlo simulations is important but just definitional and advantages/disadvantages against other analytical methods.

Sampling and Estimation

Again, fairly unimportant material but it is mostly conceptual so it should be easier to remember. You won’t need much in the way of formulas but will want to understand the ideas and differences between the different sampling plans. Remember that a good estimator is unbiased, efficient and consistent.

  • Understand the difference between simple random, systematic and stratified sampling as well as advantages/disadvantages around each.
  • A carryover from the previous reading, be able to calculate and interpret confidence intervals for the different distributions. Remember, if the sample size is larger than 30 then the z-score can be used as a proxy for the t-score.
  • Probably the most important material in the reading is that on data mining, sample selection, survivorship, look-ahead and time-period biases. Understand these and the different situations in which they might occur.

Hypothesis Testing

  • Understand the difference between the null and alternative hypothesis and be able to calculate the test statistic. The p-value is the lowest level of significance at which the null hypothesis is rejected.
  • Understand the difference between a Type I and Type II error
    • Type I is where you reject the true null hypothesis (i.e. saying that the statistic falls outside of the confidence interval in a normal distribution when it does not)
    • Type II is where you do not reject a false null hypothesis (i.e. saying that the statistic lies within the confidence interval when it does not)
    • Remember the rules for setting a low or high level of significance (1% or 10%) depending on the penalty for committing either error (i.e. 1% significance if you do not want to make Type I error, 10% significance if you do not want to make Type II error)

Technical Analysis

Again, not as important as the other readings but make sure you have a basic understanding in case you see something on the exam. Understand the assumptions, especially how they relate to the theory of efficient markets, and the comparison to fundamental analysis. It does look like the Institute is putting in more charting information in the curriculum so understand the basic definitional ideas around the vocabulary (i.e. head and shoulders, double tops, neckline, etc.)

Understand what volume says about technical analysis, i.e. intensity of confidence in an up or down move.

The technical indicators are of relatively more importance than the material on charting. Understand the concept behind the price-based indicators, momentum oscillators, sentiment and flow-of-funds indicators and whether an indicator is giving a bullish or bearish signal.

That is a lot to take in for one week so you will probably want to cover one study session per week. It is pretty basic stuff if you have at least an understanding of basic statistics and algebra. We’ll start on the Financial Reporting material next week.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 17:08 pm

December CFA Exam Must-Know Strategy

Following our discussion last week on taking the December and June exams, we thought it would be a good time to start a series of posts to prepare December candidates for the exam. This week we will cover the basic strategy and helpful tips for the first CFA exam. Over the next couple of months, we will cover specific topic-level information within the first exam.

Follow those topic weights

The CFA Institute does not disclose the minimum passing score on any exam but has said that no one with a score of 70% or greater has ever failed. The Institute does release a topic-level breakdown of the question weights you will see on the exam, shown in the graphic below. While you cannot afford to neglect any particular topic, one of the best things you can do while studying is focus on the high-point areas on each exam.

It will do you no good to spend half your time studying Corporate Finance, even if that is what it takes to master the information, if it means performing poorly in other areas.

cfa topic weights

Looking at the chart, it should be clear that you need to focus on three or four topic areas for the first exam.

You absolutely must master the material in Ethical and Professional Standards. Not only is it carry the second most questions on the exam but it will be 10% of your next two exams as well. You’ll see additional material in the other two exams but the Code and Standards do not change so learn them early. The most challenging aspect for most candidates is that they underestimate the difficulty of the exam questions. Candidates reason that they are more or less honest people and so will intuitively know the answers to the ethics questions.

WRONG! You only need to read through a few of the end-of-chapter questions in the curriculum to see how difficult and confusing the Institute can make these questions. My suggestion, make flashcards for each professional standard for quick review. Then spend most of your time practicing questions. The best resource will be your curriculum book or those from prior years. Try getting the book from last year or the year before for another set of questions. Test bank questions are also a good resource. By practicing as many questions as possible, you will start to get a feel for how they might appear on the actual exam.

Financial Reporting & Analysis is likely the most important topic area in the curriculum across all three exams. You are testing for the designation of Chartered Financial Analyst, so you better master the topic to pass the exams and succeed in your career. There are four study sessions covering FRA for the first exam. I would say SS8, the material on the financial statements, is probably the most important.

A few keys to passing the FRA material

  • Understand how items are recorded on the financial statements – Are they historical costs or market values, are they point-in-time values or for the entire period
  • Understand the relationships between the financial statements – These are absolutely critical to your success as an analyst. Building your first proforma model will mean linking the three financial statements to your projections flow through and tell you where the company is going.
  • Understand how to adjust and analyze the financial statements through ratios, earnings quality and backing out different items. This is really the Holy Grail of the analyst’s job and you won’t be expected to do it on your first CFA exam but you will be expected to understand the very basics.

We’ll cover FRA in more detail through our topic-level breakdowns. Just remember to leave yourself plenty of study time for the topic when you are planning your schedule.

The time you spend on Quantitative Methods will depend on your prior experience with statistics. While the points in the topic are not huge over the first two exams, understanding the Level 1 material can make the material on the second exam much easier. For this reason, I would suggest spending a little more time to get it down. Study Session 2 is relatively basic material but absolutely fundamental to our industry so you need to understand it.

While Equity Investments is only 10% of your first exam, I would recommend spending more time here as well because it will save you a lot of time on the next exam. Study Session 14 is the more important but SS13 is relatively basic and should be easy enough to get the general ideas. In particular, the material on Industry and Company Analysis (reading 50) and Equity Valuation (reading 51) are extremely important and very testable.

If you do not have a background in debt instruments, you’ll need to spend a little extra time in Fixed Income as well even if it is not a lot of points on the first exam. The basics on pricing and valuation that you learn on the first exam will be needed to understand the material in the other two exams.

Key Resources

While the curriculum is the last word for exam prep, it is simply too long to make it your only resource.

I would recommend you read through a study guide for each topic before you read through the curriculum. This is going to help you quickly get the basic ideas and will help speed your reading through the long curriculum readings. A lot of the curriculum is academic and a little dense so without a quick primer, you could find yourself re-reading passages just to understand what you’re looking at.

Flash cards are another key resource. These are a great resource to carry around with you and get a little extra studying in whenever you have down-time. Don’t buy your flashcards though. Half the benefit is from writing the problems out so you will want to make your own. I talk through how to make a set of quality flash cards in a prior post.

Practice problems, whether from the end-of-chapters or a study bank, are likely the number one reason candidates pass the exam or not. Sitting there reading the curriculum, and other passive learning techniques, will only help you retain about 20% of the material. Actively working through practice problems can help you retain at least 80% and get you well on your way to passing the exam.

As in the ethics material, a lot of candidates underestimate the difficulty of exam questions. You really need to study the practice problems to see what you will be up against for those six hours in December. I usually recommend doing at least 900 practice problems throughout your study plan.

A basic strategy

It is said that the human brain needs to see/experience something upwards of six or seven times to assimilate it into long-term memory. You’ve likely seen this in your daily life. Do you usually remember a phone number by just seeing it one time? No, you need to say it and see it a couple of times before you are able to remember it later.

The same can be said for preparing for the CFA exams. Plan on seeing or practicing the material at least 5-7 times before the exam. If you are breaking the study sessions into a weekly plan, it may look something like this:

Monday: Read study guide material
Tuesday: Practice problems and flash cards
Wednesday: Read curriculum and 30 minutes practice problems
Thursday: Finish curriculum and 30 minutes practice problems
Friday: Test over the material and flash cards
Saturday: Review study guide material and 30 minutes practice problems

By combining study guides, flash cards, practice problems and the curriculum you will be able to cover the material multiple times. By using multiple resources, you avoid getting bored looking at the exact same material every time. Notice, even on the reading days, I have added some practice problems. This is to reinforce the material you learned with active engagement.

I was quite surprised how general the questions were when I took the Level 1 exam. The first exam is an indoctrination into the industry and you are not expected to know all the details. Start by understanding the reasoning and basic ideas within each topic area and then move on to get the details. Understanding the basic reasoning in each Learning Outcome Statement (LOS) will usually help you eliminate at least one of the three answers provided.

Next week, we will start working through some of the topic areas on the Level 1 exam. We will spend most of our time focusing on core topics like Ethics, Financial Reporting, Quantitative Methods and Equity Investments but will try to touch on each topic over the next couple of months.

‘til next time, happy studyin’
Joseph Hogue, CFA

Your December Level I Checklist

Just four weeks left to the big day for December candidates and I am remembering my own Level I exam with fondness. I took the exam in June 2009 and did fairly well but there were still a few things I wish I had taken care of before the test. Most of these scattered within older posts on the blog but I thought I would compile them here so you don’t have to search.

Do at least 900 practice problems


I can’t think of a better way to prepare for the exam than by doing exam-type questions. From my own experience, along with talking to candidates, 900 practice problems seem to be a pretty good target for understanding the curriculum. Do at least 360 of these in 180-question blocks to simulate a full exam. Make sure you are tracking your performance within the topic areas as well as across the curriculum.

Don’t let the Ethics material surprise you


Ok, this is more of a goal than a checklist item but it is more important than you know. Everyone thinks they know ethics until they take the test. The Institute is legendary for writing questions and answer choices that have you second-guessing yourself. The material is worth 15% of your score and a big part of the other exams so you need to master the topic. The end-of-chapter questions are a good example of how the exam questions will go. If possible, I would recommend getting other year’s texts and doing the questions in those as well (ask other candidates or your local society who might have the books).

Studying financial reporting will pay off now and in future


This section and the one on Ethics account for more than a third (35%) of your total score and a big chunk of the other two exams. As a financial analyst, does it surprise you that the topic of Financial Statement Analysis would be a big part of the test? More than just passing the Level I exam, you need to master this basic material to be able to handle the Level II and III material.

Think breadth not depth


Candidates rightly say that the Level I exam is a mile wide and an inch deep while the Level II exam is an inch wide and a mile deep. The exam surprised me for its breadth of material but was actually fairly easing on detail. You really need to master the two sections above, but I would focus on quantity rather than quality for the rest of the curriculum. Make absolutely sure you have a good understanding of all the definitions and the larger concepts.

Note that this changes in Level II where I feel the focus is on a detailed understanding of less breadth.

Check those docs and your test route


How much would it suck to do all that studying and then not be able to take the exam? Nobody believes they will have a problem on test-day but there are always candidates at every site that arrive late or do not have the correct documents. I put together a test-day checklist in a previous post and found here, that includes Institute policies and suggestions for that all important day.

https://www.finquiz.com/blog/2012/05/28/cfa-exams-last-minute-checklist/

Not a complete to-do list but I think it will get you 80% of the way. Please let us know your own list in the comments below so we can pass them along.

‘til next time, good luck in December.
Joseph Hogue, CFA

CFA Level 1 Review, Derivatives

Study session 17 in the CFA Level 1 curriculum consists of six readings (60-65) covering derivatives. The material is still fairly conceptual but is pretty lengthy. While the topic is only worth 5% of your Level 1 score, you will need it as a base for the 5% to 15% in each of the next two exams. As with most of the CFA Level 1 curriculum, focus first on the basic concept and differences, advantages and limitations of each type of derivative.

Derivative Markets and Instruments
Derivatives are called such because they are instruments that ‘derive’ their value from the value of an underlying asset. The value of an option, futures contract or swap depends on the price of the asset on which it is written. How much you would pay for an option on a share of Apple depends on how much a share of Apple stock is worth.

Derivatives are traded either over-the-counter or on an exchange. The distinction is important and very testable. Over-the-counter is between two private parties while exchange traded is usually through a clearinghouse (a third party that takes both sides with each party). Exchange-traded derivatives usually have less transaction costs, are standardized and expire on regular calendar dates. The do not carry counterparty risk because of the clearinghouse and are usually marked –to-market with a margin. OTC derivatives have counterparty risk because you don’t really know if the other party can deliver but they are completely customizable to your needs.

Forwards and futures are basically the same instrument except futures are exchange traded while forwards are OTC. Swaps are an OTC agreement between two parties to exchange principal, i.e. an interest rate, currency or commodity.

An option gives the party the right to buy/sell an asset but not the obligation. The buyer can pay a small premium now for the privilege of locking-in the buy/sell price on a later date but does not have to worry about the obligation to deliver. Besides the derivatives material, options will be important in bonds and asset-backed securities as well.

Forward Markets and Contracts
Besides the basic concepts of a forward, the payoff calculation of a FRA is the most important and testable material here. The payoff for a Forward Rate Agreement is:

((Expiration rate – Contract rate) (days in rate/360)) divided by ((1+epiration rate) (days in rate/360))
Multiplied by the principal on the contract.

Think about it logically and the formula becomes easier to remember. You are looking for the difference in rates (adjusted for the term of contract since rates are quoted on an annual basis) as a percentage of the expiration rate. This factor is then multiplied by the contract principal (the notional) to get the payoff. *remember to use 360 days

Futures Markets and Contracts
Mostly conceptual stuff here with the focus on advantages of futures over forwards and the different participants in the futures market.

Option Markets and Contracts
Know the basic concepts behind a put and call as well as how to calculate the payoff at expiration. Most options are pretty easy to calculate but rate options get a little more complicated.

The payoff on a rate option is: (principal) *((exercise rate – rate at expirate)(days in rate/360))
*Remember, a rate option isn’t paid at expiration, it is paid the number of days in rate after the expiration (i.e. an option on 180-day LIBOR that expires in 90 days would be paid in 270 days but the payoff amount is calculated at expiration.

The put-call parity formula can be a pain but you will need it here and it will appear again in the second exam, so spend the time to learn it. Understand how puts and calls can be used to create a synthetic position.

Know the Greeks and their respective measures. Again, something were you just need the basics here but more detail in subsequent exams.  Three of the Greeks start with the same letter as the definitional word which is how I remembered them.

  • Delta- sensitivity to price change
  • Gamma- sensitivity to delta change
  • Rho – sensitivity to rate change
  • Theta – sensitivity to time change
  • Vega – sensitivity to volatility

Swap Markets and Contracts

Most swaps do not include an exchange of principal at initiation and the payments are netted but currency swaps do because the notionals are in different monies. Be able to calculate the amounts exchanged at initiation as well as on settlement dates.

Be able to calculate the basic payments for an equity swap for both parties and the reasons one would enter into a swap (i.e. protect capital gains while avoiding taxes or to hedge volatility)

Risk Management Applications of Options Strategies
I’m pretty active in the options market, both as a hedge and for investment, so I found this material interesting when I took the exam. The two main strategies are covered calls and protective puts (also called portfolio insurance). You’ll need to understand the basics of each, why investors might use them and to calculate the payoff at expiration.

  • Protective put: buying a      put option against a long position has limited downside but maintains      upside potential.
  • Covered call: Selling call      options against a long position has more downside risk and limited upside      potential but involves collecting a premium instead of paying for      protection. The strategy is best if rates/prices do not change.

Study session 18 concludes the CFA Level 1 curriculum with two readings covering alternative investments.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review, Fixed Income Overview

Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings (52-55) covering the basic concepts in debt securities. The topic is worth 12% of your Level 1 score but you really need these core concepts to understand the later material the other two exams. The topic will be worth about 10% and 15% of your Level 2 and Level 3 exams.

Looking back on the Level 1 curriculum for these posts, it strikes me how effectively the Institute manages to work candidates into a topic with basic concepts and ideas. I’ve heard the Level 1 exam described as a mile wide and an inch deep because of the breadth of information involved but the difficulty is offset by not requiring too much detail.

This is a key point you need to remember when studying for the first exam. Get the key concepts and vocabulary first. Not getting caught up in too much detail is going to help you cover the curriculum as many times as possible. Going over the material multiple times helps to commit it to memory and helps you pick out the correct answer out of three choices. You’ll still need a fair amount of detail, but the first exam is definitely a bird’s eye view of the material.

Features of Debt Securities
Understand the basic types of affirmative and negative covenants like paying interest & taxes, meeting financial ratios, limitations on additional debt, and restrictions on asset sales.

Definitions and just knowing the lingo is always important. Know what a coupon is and understand what happens to the price if the coupon rate is higher or lower than current market rates. Think about it intuitively. If a bond offers a higher coupon rate than you can find in the market, you are going to be willing to pay a premium on the price, and the opposite is true for a coupon rate below the current market yield.

Understand the basic idea behind call and put provisions, sinking funds, repurchase agreements and prepayment. Remember, the full or dirty price is the agreed price plus all accrued interest.

Risks Associated with Investing in Bonds
There are 11 basic risks listed with bonds: interest rate, call and prepayment, yield curve, reinvestment, credit, liquidity, exchange-rate, volatility, inflation, event, and sovereign risk. Some (interest rate, prepayment, yield curve) are extremely important and you will be seeing a lot of the curriculum focus on detail but you need to have an understanding of the basic factors within each.

The inverse relationship between rates and price underlies interest rate risk. As rates increase, the price of a bond decreases because investors can get a better rate in other products. Understand how maturity of the bond affects the change in price, i.e. longer time left means bigger price swings because you could be earning more/less for a longer time. Duration is the measure of rate risk and you need to remember the formula for the exam = (Price at lower rate – Price at higher rate)/ (2*initial price* change in yield)

Prepayment risk is when the bond issuer (or mortgage holder) has the option to buy back the product. Remember, all options have value and the value of this call feature will be more valuable as rates decrease.

Reinvestment risk is associated with the need to reinvest payments of interest and principal at lower rates than the bond offers. Zero coupon bonds have no reinvestment risk because they have no payments until maturity while amortizing securities have more risk because they pay off principal and interest.

Understand the three types of credit risk: default, credit spread, and downgrade risk.

Understand the threat that inflation poses to bonds as fixed-income products. This means that even as the value of the currency depreciates, the investor only receives the set coupons and principal so the bond is worth less in real terms.

Overview of Bond Sectors and Instruments
This reading is of secondary importance and you really only need a basic idea of the seven sectors of the bond market and an overview of their characteristics.

Sovereign bonds: Government issued and relatively lower risk. They can be issued in local or foreign currencies. Understand the basic differences of the U.S. debt like T-notes, T-bonds, Strips and TIPS.

Semi-government: These are issued by a quasi-government agency and often carry an implicit guarantee. The focus is on agency mortgage debt and the types of CMO and MBS, think Fannie Mae and Freddie Mac a few years ago.

Municipal or province: Like sovereign bonds but issued by smaller authorities like towns and cities. Understand the difference between tax-backed and revenue bonds and the effect on risk. The interest is often tax-advantaged for taxes owed to the issuing municipality or state.

Corporate Bonds: Understand the four factors used by credit rating agencies (character, capacity, collateral, and covenants). This section has a few formulas and is probably one of the more testable in the reading.

Mortgage backed securities: Understanding structure and prepayment risk is the important material here and will be used for more detail in the Level 2 exam.

Asset backed securities: Understand the types of internal and external credit enhancements as well as the role of special purpose vehicles.

Collateralized debt obligations: These are basically the same as asset-backed debt but the backing for the bond is a diversified pool of different debts, i.e. domestic/foreign bonds, bank loans, distressed debt, ABS, and MBS.

Understanding Yield Spreads
An extremely important reading and the setup for many formulas in the Level 2 exam. Understand the effect of monetary policy (open market operations, discount rate, reserve requirements, and verbal notes) on rates.

Understand the theory behind the four shapes to the yield curve and what they say about the outlook for rates and the economy: positively-sloped (normal), flat, inverted (downward-sloping), and humped.

Understand the three theories of term structure: pure expectations, liquidity preference, and market segmentation.

1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.

2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.

3)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.

Study session 15 in the CFA Level 1 curriculum concludes the topic area with four more readings in fixed income.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: July 18, 2016 at 16:45 pm

CFA Level 1 Review, Equity Investments

Study session 14 in the CFA Level 1 curriculum concludes the equity topic area with three readings (49-51) on valuation of equity securities. The topic area is arguably one of the single most important in the entire curriculum. It is worth 10% of your Level 1 exam, about 25% of your Level 2 test and 10% of your last exam. As with most of the curriculum throughout the first exam, you will need a strong base to be able to move into deeper detail for the other exams.

Overview of Equity Securities
This is a very basic reading and almost entirely conceptual. Look for the list material and any comparisons with other types of investments, i.e. the differences between debt and equity.

Understand the differences between common and preferred shares like: payment order of dividends, distribution of net assets in a liquidation, and voting rights.

The characteristics of a depository receipt and the types of ADRs is important. You probably won’t need the full detail on types of ADRs but remember that Level  II and III are traded on the exchanges. Level I ADRs are subject to limited reporting requirements and only trade on the OTC market. Regulation S depository receipts are not subject to registration requirements and are only privately placed.

Understand the basic return and risk characteristics of equities, pay attention to standard deviation.

The material on ROE, the cost of equity and investors’ required rates of return is probably the most important in the reading. These will be fundamental concepts across the three exams. Understand how to use the DuPont formula to analyze the sources of changes in a company’s ROE.

Introduction to Industry and Company Analysis
Writing blog entries for the 18 study sessions across the three exams, I am struck with a sense of déjà vu because the same concepts reappear so many years. You will revisit industry and company analysis in both the Level 2 and 3 exams. I know you are tired of studying and trying to find time as it is but spending a little extra time on the Level 1 curriculum to absolutely master the material will pay off big time in the next two years.

Understand the differences between cyclical and non-cyclical companies like stability of demand for products/services and variability in profits due to fixed costs. Understand the basic differences between the sectors, i.e. basic product category and demand stability. If it helps, you might try looking at the fact sheet to the Select Sector SPDRs ETF funds which provide descriptions of each sector.

Porter’s Five Forces Framework is something you will see again so you need to understand it in detail. Understand each of the five forces and how it relates to industry analysis. Beyond the exam, the concept is pretty well known in the business world and you’ll need to know it sooner or later.

  • Greater rivalry (competition) within the industry means lower profitability as companies compete on price and brand identification.
  • The higher the threat of new entrants the lower profitability will be as companies lower prices to avoid attracting competitors. Barriers to entry like high capital expenses or regulation important here.
  • The lower the threat of substitutes the higher the profitability as companies can exercise more control on prices. Pay attention to switching costs for consumers.
  • Bargaining power of buyers is relative to the number of consumers and relative size of each for the product.
  • Bargaining power of suppliers is relative to the number of suppliers for an input and how easily it is to switch suppliers.

The Industry Life Cycle model is also pretty testable so understand the stages (embryonic, growth, shakeout, mature, and decline) and characteristics of each.

Equity Valuation: Concepts and Basic Tools
Understand the differences and advantages/limitations of each of the three major categories of valuation models:

1)      Present value or DCF models provide an intrinsic value estimate of the shares as the sum of future cash flows.

  1. Understand the Gordon growth model and its assumptions, i.e. growth remains constant indefinitely, dividends grow at a constant rate, and the growth rate is less than the required rate of return. A multi-stage DDM is necessary when growth is not constant.
  2. Pay attention to the FCFE model and how it can be used on non-dividend paying stocks

2)      Market multiple models estimate value through a multiplier with earnings, sales, enterprise value or asset-values. These can be applied on a trailing or forward basis.

  1. These are fairly easy to understand but you need to know the limitations, i.e. the multiples are based on trailing (past) data and may not be a good predictor of the future, the multiples reflect relative valuation compared to peers or the index but not intrinsic value.
  2. Understand the difference between the trailing multiple (past data) and the justified (forward) multiple which is based on forecasted data.

Enterprise value is the market cap plus market value of preferred and debt minus any cash and short-term investments. It reflects the real economic value of the company and is helpful when comparing companies with different capital structures.

Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review, Equity Investments

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48) in equity market structure and efficiency. The material is almost completely conceptual and any student of finance will already have seen it. If you are new to the industry, spend a little time to get the vocabulary and concepts. The topic area is only worth about 10% of your first exam but is extremely important in the other two tests.

Market Organization and Structure
This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16

Pay special attention to the information on orders as you will need it for attribution analysis in the Level 3 exam and it is highly testable in the first exam.

Security Market Indices
The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.

Market Efficiency
The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form.

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea.

Study session 14 in the CFA Level 1 curriculum continues the equity topic area with three readings on valuation of equity securities.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review, Portfolio Management

Study session 12 in the CFA Level 1 curriculum includes four readings (42-45) on portfolio management and sets the basis for further material in the other two exams. While the topic area is only worth about 5% of your Level 1 test score, it makes up about 10% of the second exam and is the core focus on the third exam. The material here is pretty basic and easy to understand if you give it a little time and do the readings.

Portfolio Management: An Overview

The different types of clients, individual and institutional, are important here. Understand the basic return objectives and risk tolerance for individuals and the seven institutional clients (banks, pensions, insurance, endowments, foundations, investment companies, and sovereign wealth funds) as well as their time horizon, liquidity/spending needs and special circumstances for each.

Individual clients objectives and special constraints vary by individual.
Pension plans usually have long time horizons, high risk tolerance, varying income and liquidity needs.
Endowments and foundations usually have very long time horizons, high risk tolerance, with income needs based on that of college or foundation programs.
Banks have shorter time horizons, low risk tolerance, high income needs to pay interest and operational expenses.
Insurance companies have short horizons for P&C and long time horizons for Life companies, while the risk tolerance and income needs vary.

* Memorizing the needs is not nearly as important as knowing why they differ. You will need to understand this and be able to explain in on the Level 3 essay section, GUARANTEED.

The actual steps in the portfolio management process are of less importance than understanding individual sections in the process. Just remember that understanding the client’s needs through an IPS always comes first, followed by putting the portfolio together and then monitoring and rebalancing.

Target asset allocation is an important concept and you absolutely need to get the basics here to go into detail in Level 2. Weights are determined based on capital market expectations and the risk/return analysis of asset classes according to the needs of the specific client.

Understand the basics behind mutual funds, ETFs, hedge funds, and venture capital funds. Pay special attention to the differences between mutual funds and ETFs.

Portfolio Risk and Return (part 1 and 2)

These readings are more quantitatively focused and will set the stage for your quant material in the next exam. All the calculations can be done fairly easily on your calculator.

Understand the difference between arithmetic and geometric return. Geometric return measures the compound return and is appropriate when there are multiple periods. Arithmetic return is the average and is easier to compute and more commonly used.

Understand the IRR and how to work the cash flow functions on your calculator.

Remember, the asset class weights must sum to 1 for a portfolio return. Beyond that, it’s pretty easy. Just take the return of each asset times its weight and add them all up.

The calculations behind gross, net and real return are probably of lesser importance than how they differ. Understand what comes out of gross return (trading expenses, managerial and administrative expenses) to get net.

Variance and covariance, and correlations can seem overly lengthy and complex but you must know how to calculate them (despite the fact that your calculator can do it for you). Put them in some practice problems on flash cards and drill until its natural to run through the formulas.

Remember the three percentages to a normal distribution. +- 1 deviation holds 68% of observations, 95% within two deviations and 99% within three deviations.

The utility function is one of the few formulas in the curriculum that is pretty inconsequential in practical terms but seems to show up on exams because it’s easily testable. Just put it on a flash card and learn it.

Be able to calculate the capital allocation line and understand the idea behind indifference curves and the optimal portfolio. Understand the capital market line and how it relates to the CAL.

The capital asset pricing model will come into the curriculum several times and is the basis for many assumptions and valuation. At this point, just remember the basic formula and the assumptions underlying the model as well as limitations.

Basics of Portfolio Planning and Construction
Used to be, you didn’t start into the IPS until Level 2 and then really got into detail in Level 3. The Institute has moved it up to level 1 so that should give you an idea of its importance. We covered the basics of the IPS (Return Objective, Risk Tolerance, and 5 Constraints) in a previous post on Level 2 so click here for the summary.

Understand the criteria to specifying asset classes and how strategic asset allocation fits into portfolio construction. Understand the difference between SAA and tactical asset allocation. In TAA, the manager deviates from policy weights according to temporary changes in short-term capital market expectations but the long-term policy weights are constant.

Understand the difference and advantages/limitations between top-down and core-satellite.

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings in equity market structure and efficiency.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review Corporate Finance

Study session 11 in the CFA level 1 curriculum is a long one with six readings (36-41) covering Corporate Finance. The good news is that it is almost all conceptual material and anyone with undergraduate-level coursework in Finance will have seen much of it. As with much of the material at Level 1, you need a good base of understanding because you will be expected to know it in the other two exams.

The readings here are good, “what-if,” material as in what if you want to transition into management or corporate finance from investment management but neglected this really core information.

Capital Budgeting
Remember that only incremental cash flows are to be considered in budgeting. These are the additional inflow directly associated with the project. Sunk costs, like spending on impact or research, are not to be included because they are already spent. Financing costs are also not included because they are already factored into the discount rate.

Understand the difference between independent and mutually exclusive projects. Most questions on the exams will be about mutually exclusive projects, only able to go with one project. This is capital rationing in contrast to unlimited funds.

The biggest part of the reading is remembering all the measures: NPV, IRR, Payback & Discounted Payback, AAR, and PI. While NPV and IRR are the most important and will be seen many times in the curriculum, the others are pretty basic and easily remembered. Along with the calculations, you should know advantages/limitations of each method and the decision rule.

Remember, IRR is less subjective and widely accepted but based on the assumption of reinvested cash flows (not always realistic). The method will give multiple IRRs with un-conventional cash flows so the NPV method may be preferable.

NPV directly measures the increase in value to the firm and assumes reinvestment at the opportunity cost of capital, r.

Cost of Capital
Remember the preference continuum for estimating capital structure: target capital structure > current capital structure (weighted by market value) > trends in capital structure and management statements  >  averages of comparable companies’ capital structure

The various methods of estimating cost of debt and equity are probably the most important material in the reading.

Yield to Maturity or Debt-Rating for debt – YTM can be found using your calculator (N, PMT, FV, PVà compute i/Y) but remember to multiply the rate by number of coupons per year. Debt-rating is pretty easy using the yield on comparably rated bonds. ** The cost of debt is NOT the coupon rate.

Cost of equity: Dividend discount, bond yield plus risk, CAPM
Remember, estimated growth equals the retention rate times ROE.

Measures of Leverage
Understand the difference between operating leverage and financial leverage. Operating leverage refers to the fixed costs in operating while financial leverage refers to the debt costs in the capital structure. Remember that the higher the leverage, the higher the volatility and risk in net income.

Be able to calculate DOL, DFL and DTL using income statement items (changes in operating income, units sold, EBIT, Sales) or by the per unit inputs (quantity, price, variable operating cost per unit, fixed operating cost).

Companies with a high degree of financial leverage may be able to exit bankruptcy through restructuring (going concern) while those with high operating leverage have less flexibility and may be liquidated.

Dividends and Share Repurchases

Types of dividends: cash, stock, stock split, and liquidating dividend.
Remember the chronology for dividends: declaration dateàex-dividend dateàrecord date(typically two days after ex-div)àpayment date.

Share repurchase methods: open market, tender offer, dutch auction, and repurchase through direct negotiation.

Remember the advantages/disadvantages of each form of dividend or repurchase plan and how each impacts shareholder wealth.

Working Capital Management
There is some really good corporate finance material here but the specific measures are probably most important for the CFA exams. You’ll see these again in the equity investment material.

Liquidity measures: current and quick ratio (know the difference)

Turnover ratios: accounts receivable, inventory turnover, number of days receivables, number of days payable, number of days inventory (be able to calculate the operating and net operating cycle)

Remember the difference between money market yields, discount basis yield and the bond equivalent yield. You use 360 days for money market and discount yield and 365 days to calculate the BEY.

The cost of trade credit is a very testable formula. Put it on a flash card and learn it.

Corporate Governance
Remember the best-practices information here:

  • A majority of board members should be independent
  • Nominating, compensation, and audit committees should be completely independent members
  • Board should have resources to hire external consultants
  • Annual elections allow quick action by shareholders
  • Independent members of the board should meet regularly without management
  • Board should conduct an annual self-assessment
  • Company should adopt a code of ethics
  • Compensation and the incentive structure should align management-shareholder interests

Study session 12 in the CFA Level 1 curriculum covers the basics of portfolio management.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level I Review Financial Reporting Quality and Shenanigans

Study session ten in the CFA Level 1 curriculum curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35).

Financial Reporting Quality
The reading, and much of the curriculum in FSA, revolves around your ability to understand aggressive and questionable accounting practices. Companies using more conservative practices are going to have higher earnings quality because the doubt will be on the side of more favorable accounts.

A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Understand that management might manipulate earnings to the downside as well as to the downside.

The list material behind red flags is fairly testable so understand the risks.

  • Incentives and pressures include pressure on management to meet expectations, financial targets, debt covenants, and their own financial well-being
  • Opportunities include the nature of the industry, a complex organizational structure, ineffective monitoring, a significant number of estimates build into the accounting system, high turnover or ineffective audit staff
  • Attitudes and rationalizations include the use of inappropriate accounting, poor communication channels, failure to correct reportable conditions, and a history of violations

The most important material is the specific warning signs and the measures to spot them.

  • aggressive revenue recognition (bill-and-hold sales, sale-leaseback, swaps and barter to generate sales)
  • operating cash flow out of line with earnings (CFO/Net Income)
  • Classification of expenses as extraordinary or nonrecurring
  • LIFO liquidations
  • Margins significantly out of line with peers without other explanations
  • Assumptions behind depreciation
  • Assumptions used in pension accounting
  • Fourth quarter surprises that cannot be attributable to seasonality
  • Excessive use of operating leases or other off-balance sheet financing

Accounting Shenanigans on the Cash Flow Statement
Understand that the cash flow statement is less easily manipulated but management can still distort the various accounts.

  • Stretching out payables (look for a trend in days sales payable)
  • Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods
  • Securitization of receivables and whether it is through a bankruptcy-remote VIE
  • Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
  • Stock buybacks to offset dilution

Financial Statement Analysis: Applications
Really nothing new in this reading, just a review of the previous material. Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets). Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.

Study session eleven in the CFA Level 1 curriculum is an extremely lengthy (six readings) on Corporate Finance. Much of it is fairly basic and will be a repeat of your intermediate finance courses from college. If your background is not in finance then you will need to spend some extra time because the concepts will be revisited in the second exam as well.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review Financial Reporting and Analysis

Study session nine in the CFA Level 1 curriculum details financial reporting & analysis with four readings (29-32) covering inventories, long-lived assets, taxes and long-term liabilities.

Inventories
The material revolves around the choices for inventory accounting (FIFO, LIFO, Weighted Average, and Specific ID). You absolutely must know the FIFO AND LIFO concepts as well as how the choice affects ratios and the income statement. You will need this going into the CFA level 2 exam so don’t ignore it.

FIFO expenses the first items purchased for cost of goods sold, which are usually cheaper given inflation. This will lead to higher earnings from the lower expense. Ending inventory, working capital, shareholders’ equity, earnings, current ratio, ROA, ROE and the profit margin are usually higher using FIFO accounting.

LIFO expenses newer inventory first so ending inventory will usually be lower in an environment of increasing prices.  Understand what happens in an inventory liquidation and what it means for taxes, cash flow and earnings. After-tax cash flow, debt-to-equity, and asset turnover are usually higher under LIFO accounting.

Understand how to convert LIFO to FIFO statements. Add the ending LIFO reserve to inventory. Subtract the change in LIFO reserve from the COGS for FIFO cost of goods sold. Adjust the LIFO net profit by the change in LIFO reserve and the tax rate for the FIFO net profit.

A table with LIFO and FIFO across the top and all the relevant ratios/financial statement line items down the side makes it easier to see how the two methods can cause differences in your analysis. Rather than just writing higher or lower, understand why the effect happens (i.e. shareholders’ equity is usually higher with FIFO because earnings and inventories are higher).

Long-lived Assets
Much of the reading revolves around the capitalizing/expensing debate. Understand the rules for capitalizing and how/why managers might want to bend them.

Understand how the financial statement accounts and ratios differ under capitalizing or expensing. Return on equity, ROA, profit margin, pretax cash from operations, earnings, and shareholders’ equity will be higher under capitalization. Cash from investing, asset turnover, and debt-to-equity will be higher under expensing.

Understand that, as an analyst, you may want to adjust the statements for capitalized interest by: add capitalized interest back to interest expense, reclassify capitalized interest from investing to operations on the cash flow statement, remove capitalized interest from depreciation expense.

Remember the difference and how to calculate the methods of depreciation: straight-line, accelerated, and units-of-production and be able to estimate the age of fixed assets.

Debt-to-equity and asset turnover will be higher under an accelerated method of depreciation while ROE, ROA, profit margin, shareholders’ equity, and earnings are higher under straight-line.

Understand the concepts and general rules behind intangible assets and impairment.

Income Taxes
You will need to know the difference between accounting  profit and taxable income and how to calculate deferred tax assets and liabilities. A deferred tax liability is taxes that will be paid in the future because the company reported lower taxable income than profits, while a DTA is taxes that will be saved in the future.

Understand the concept behind temporary and permanent differences. Tax-exempt interest, allowable tax credits and life insurance premiums are the usual examples for permanent differences.

Be able to determine the income tax expense under the liability method: Taxes payable + change in DTL – Changes in DTA net of valuation allowance.

Non-Current Liabilities
You need to be able to work through the calculation for interest expense, coupon payment and the ending carrying value of a bond. It can be a pain at first isn’t too difficult once you understand what is happening.

The interest expense is just the ending carrying value times the market rate times ½ for semiannual bonds. Reduce this by the interest payment (face value * coupon rate*1/2) for the change in the liability. The prior ending carrying value plus the change in liability is your new carrying value.

Understand how a change in interest rates affects the market value of debt and economic gains. An increase in rates will decrease the value of debt and lead to an economic gain.

Remember the five main debt covenants: limitations on asset disposal, restrictions on debt issuance, limits on use of borrowed funds, collateral maintenance, and dividend restrictions.

Study session ten in the CFA Level 1 curriculum concludes the material on FSA with reporting quality and some applications.

‘til next time, happy studyin’
Joseph Hogue, CFA